Last Updated on 14 October, 2021 by Samuelsson
Some traders don’t like to stay in a trade for too long and often prefer a trading approach that generates quick small profits from the short-term price movements. If you’re the type of trader who likes to grab a small profit fast and quickly move on to the next opportunity, then scalping might be the trading style that suits you. But what exactly is scalping in stock trading?
In stock trading, scalping is an intraday trading style whereby the trader enters and exits a position in a space of few seconds to some minutes and does that multiple times throughout the day. Rarely do scalpers leave their trades open for hours. Scalping emphasizes profiting from the volume of trades placed, instead of focusing on maximizing the capital gains on each trade.
In this post, you will learn the following:
- What scalping is and how it works in stock trading
- Whether scalping is legal
- How you can scalp a stock
- The pros and cons of scalping
- Scalping vs. day trading
- Scalping vs. swing trading
What is scalping, and how does it work in stock trading?
Scalping is an intraday trading style whereby the trader opens and closes a trade in a space of few seconds to some minutes to profit from small price movements. The trader does that multiple times throughout the day and makes small profits per trade, which adds up to a lot after several trades. Scalpers rarely leave their trades open for hours because the trading style aims to make quick trades on small timeframes, cashing out the position as soon as it becomes profitable, and then repeating the strategy again and again.
In stock trading, this trading style emphasizes profiting from the volume of trades placed, instead of focusing on maximizing the capital gains on each trade, so the traders try to profit off of small price changes by reselling immediately they are in profit. Unlike in day trading where a trader can make a few trades in a day, scalping prioritizes making high volumes of trades and small profits per trade.
In today’s market, scalping is mostly automated, with smart algorithms making high-frequency trading. It is almost impossible to scalp the market with a discretionary approach. However, when done manually, the trader must have a strict exit strategy because one large loss could eliminate all the accumulated small profits. It is, therefore, important for a scalper to have the right tools — such as a reliable broker, a fast platform with stop loss orders, a live feed, and the stamina to monitor many trades each day — if he or she is to succeed in manually scalping the stock market.
A stock scalper will make tens and hundreds of trades each day and should have a much higher ratio of winning trades versus losing ones to be successful. At the same time, the profits should be roughly equal to or bigger than losses to be able to stay profitable at the end of the day.
How does scalping work in stock trading?
Scalping is based on the idea that when you consider market volatility, it’s easier and less risky to profit from small moves in stock prices than being in the markets for a long time waiting for large moves. Hence, scalpers believe that the secret lies in staying in the market for the shortest possible time necessary to make some profits from the initial price gyrations.
While the assumption is that most stocks will complete the first stage of a movement, where the price goes from there is uncertain — some stocks may cease to advance, others continue advancing, and some may even reverse. The scalper does think he has to wait to find out, so he jumps out of the market after that initial move. If the move was in his favor, he comes out with a profit, but if the move was against his position, he closes the trade at a small loss.
The aim is to take as many small profits as possible, which is quite opposite to the trading mantra: “let your profits run” — the idea that a trader can optimize positive trading results by increasing the size of winning trades. In scalping, great results are achieved by increasing the number of winners, limiting losses, and sacrificing the size of the wins.
While other traders (swing, position, and even day traders) can make money winning half or even less than half of their trades, a scalper cannot achieve a positive with that kind of win rate — a successful stock scalper will have a much higher ratio of winning trades versus losing ones while keeping profits roughly equal or slightly bigger than losses.
To put them all together, scalping is based on the following premise:
- The less the exposure in the market, the lower the risk, since there will be less chance of running into an adverse event.
- It is easier to capture a small move because that won’t require bigger price movements that often depend on significant demand and supply imbalances; it is easier for a stock to make a $0.05 move than a $1.00 move.
- Smaller price movements occur more frequently than larger price movements — small price fluctuations still happen in relatively quiet markets, so a scalper can still trade in such markets.
The kind of market analysis for scalping
There are two major forms of analysis a trader can do before placing an order in the market — fundamental and technical analysis. For scalpers, it is only the technical analysis — and not fundamental analysis — that matters. Traders who adopt this investment style rely on technical analysis as opposed to fundamentals analysis. As you may already know, technical analysis focuses on the history of price movements, and it is done by analyzing the price and volume charts using some technical indicators and other graphical tools.
By analyzing the historical and present price movements, scalpers can observe certain patterns in the market and use them to forecast the possible price movements in the future. They try to identify support and resistance levels using moving averages and other tools and then look for trade entry and exit setups around those levels.
In contrast, long-term investors and traders follow fundamental analysis, which usually involves using a company’s financial statements, discounted cash flow modeling, management team, goodwill, and other tools to assess a company’s intrinsic value. While scalpers may trade on news or events that drastically affect a company’s value immediately after its release and, in some cases, may use short-term changes in fundamental ratios to scalp trades, they do not focus on fundamental analysis. Instead, scalpers focus mostly on technical charts, and since these charts indicate what occurred in the past, they lose value as the time horizon increases, which makes technical analysis more suitable for the short-term nature of scalping.
As we stated above, scalpers can be either discretionary or systematic traders. While discretionary scalpers trade manually and quickly make each trading decision based on market conditions using their strategies and chosen parameters to time entry and exit, systematic scalpers rely little on manual input, instead, create computer algorithms that automate scalping strategies and conduct trades without the trader making individual trading decisions.
As a matter of fact, most scalpers use algo trading systems because it has become very difficult to succeed in such a fast-paced trading style doing things manually. Obviously, discretionary scalping introduces bias into the trading process, which can pose a risk as emotions may tempt the trader to make an ill-advised trade or fail to take action at the appropriate time.
In contrast, systematic scalping does not involve human control over trading decisions, so there is little room for trading biases. With a trading system, the computer algo makes a trade whenever it sees a trading opportunity, without waiting for the trader to assess the particular details of that trade.
Is scalping trading illegal?
As with day trading, scalping in the stock market is legal as long as you observe the regulations. A retail trader can use a scalping strategy in the stock market, but he must have a margins account and meet the pattern day trading requirements, including having more than $25,000 in your trading account. Moreover, you should know that not all online trading platforms support scalping, and since scalping trading can carry significant risks, it is preferable for you to avoid it if you are still a novice trader.
The rule is different for fund managers who also trade their personal accounts. In a bid to avoid them from front-running their funds’ huge orders, which have the potential to move the market, the Securities and Exchanges Commission (SEC) tries to restrict such individuals from scalping the stock market.
How do you scalp a stock?
As a retail trader, you can scalp any stock you want, but there are many things you need to know about scalping to be able to do it the right way. Now, let’s take a look at some of those things.
Different forms of scalping in stock trading
There are different ways people use scalping when playing the stock market. Some use it as their main trading style, while others use it as a way to supplement their primary trading style. It is up to you to choose the one that suits you.
Using scalping as your main trading style
If scalping is your main trading style, you will be making tens, or even hundreds, of trades each day, so you will mostly utilize tick or one-minute charts. Those smaller timeframes are preferable because you need to see the setups as close to real-time as possible when they form. There are other supporting systems, such as Direct Access Trading (DAT) and Level 2 quotations, which are essential for this type of trading. You will need a direct-access broker to ensure instant execution of orders at interbank market rates.
Using scalping as your supplementary style
Some long-term and swing traders do use scalping as a supplementary trading approach. They try to scalp when the market is choppy or held in a narrow range. It’s a way to keep their money active and make some profits.
As a swing or position trader, you can scalp when there are no trends in your preferred timeframe. What you do is to step down to a shorter timeframe where you can see some visible and exploitable trends that you can scalp.
One other way you can add scalping to your longer time-frame approach is to use the so-called “umbrella” concept, which allows you to improve your cost basis and maximize a profit. Here is how to use the umbrella approach:
- You enter a position for a longer time-frame trade.
- Then, while the main trade develops, you identify new setups in a shorter timeframe in the direction of the main trade and trade them as well — in other words, you are scalping the setups that occur on the lower timeframe while taking your normal trades on the higher timeframe.
Key decision factors when manually scalping a stock
When you want to use the scalping approach, there are important factors you should be aware of, especially if you are following a discretionary approach. These factors will guide you in creating your trading strategy and managing risks.
- Your choice of stocks: Be sure to choose highly liquid stocks with less volatility. Those stocks tend to have narrow spreads, which you need to become profitable more quickly in each trade.
- Your choice of a broker: With scalping, you will be making a high number of trades, so the cost can easily add up. You need a broker that offers low-cost trading.
- Your analysis: You have to review relevant news sources and examine market trends to develop a key hotlist. What you do depends on your strategy and plan.
- Your entry: There have to be specific triggers for your entry, such as quarterly reporting periods, breakouts, market rallies, or others.
- Your trade management: You must have a strict trade management plan in place to minimize losses and take as many profits as possible. The goal should be to sell quickly and take profits, or exit quickly if the stock begins to fall.
- Your trading discipline: Set a goal for trades per day that you wish to accomplish based on comfort and experience
Scalping trading strategy
There are several strategies you can use for scalping, and most of them involve technical analysis via intraday charting. Here are some of the most common strategies:
Market making: With this method, a scalper tries to capitalize on the spread by posting both a bid and an offer for a specific stock at the same time. The strategy is mostly used for stocks that trading flat, despite having big daily volumes. However, this scalping strategy is very hard to trade successfully because you will have to compete with market makers for the shares on both bids and offers. Moreover, the profit is so small that any stock movement against your position can cause a loss that exceeds your intended profit target.
Large lot trading: This type of scalping is done by purchasing a large number of shares that are sold for a profit on a very small price movement. With this strategy, you will place an order for several thousand shares and wait for a small move, which is usually measured in cents. To be able to place such a huge order, the stock must be highly liquid. This strategy can be done on breakouts or in range-bound trading, and many traditional chart formations, such as cups and handles or triangles, can be used for scalping. Some traders may even code their entry and exit strategy into a trading algorithm.
Exit trading: With this type of scalping, the trader exits a position at the first sign of an exit in the pattern, which implies disregarding previous price tolerances and getting out with any gains. So, it’s a sort of strategy that hedges against any further market movement.
Algorithmic trading: In this case, the trader codes a unique trading strategy into a computer algorithm that trades on his behalf. Once the trader launches the program, it monitors the markets for trade setups and places trades without the trader’s inputs.
Steps to take when you want to scalp a stock
Here are the steps you will take to start scalping stocks:
- Open a margins account: Choose a broker that suits your style of trading. The right broker for scalping must offer direct access to the market and commission-free trading.
- Research the stocks to trade: Make use of a stock screener to choose the right stocks for scalping. The stocks must be highly liquid and have optimal volatility suitable for your trading method.
- Develop a strategy: Create a strategy for your trade entry and exits. If possible, you should code them into trading algorithms.
- Start trading: When everything is ready, you can start trading. Be sure to risk only an amount you can afford to lose.
The pros and cons of scalping
Scalping offers some advantages, but there are also some drawbacks you should be aware of. Let’s take a look at each of them:
The advantages of scalping stocks
These are some of the advantages of scalping in stock trading:
- It leverages small changes in the price of a stock: The strategy can leverage small changes in the price of a stock, which may not necessarily reflect the overall trend of the commodity’s price for the day.
- It can be very profitable: With a good entry strategy and strict trade management or exit strategy, scalping can be very profitable.
- It doesn’t require you to follow fundamental analysis: You do not have to follow fundamental analysis because it doesn’t play a significant role when dealing with only a very short timeframe. As such, you don’t need to know that much about the stock.
- It has very little market risk: There is very little market risk involved, as it is designed to limit the losses from any one stock by making tight leverage and stop-loss points.
- It is a non-directional strategy: Scalping is a non-directional strategy; the markets do not need to be moving in a certain direction before you can take advantage of it. You can scalp when markets are moving up and down.
- It can easily be automated within the trading system you are already using: Some scalping strategies can easily be automated within the trading system that you are already using because they are usually based on a series of technical criteria.
The drawbacks of scalping stocks
Despite the many advantages of scalping, there are also some drawbacks to using the trading style. These are some of them:
- It comes with high transaction costs: Scalping involves frequent trading; you may be making dozens or hundreds of trades per day, and the cost can easily add up. Though not a problem if you are in a winning run, it can be when a losing streak sets in.
- It requires greater leverage to make a profit: The strategy requires you to use huge position sizes to generate enough profit, but the risk of trading huge position sizes just to generate a small profit per share may not be worth it. Moreover, opening a large number of trades comes with higher transaction costs, especially if you are paying a commission per trade rather than per share, but even when the commission is per share, the cost of commission as a percentage of the small profit made per share may be too high.
- It can be time consuming: With scalping, you may be taking dozens or hundreds of trades a day, which can be very time consuming as it requires high levels of concentration.
Scalping vs. day trading: is scalping better than day trading?
We can say that scalping is a high-frequency form of day trading, so both trading styles are at the mercy of FINRA’s pattern day trader rule. You also have to maintain a $25,000 minimum balance in your account when scalping.
While day traders may spend hours in a position to see a trend play out, scalpers care about only the incremental movement within a pattern. Evidently, some day traders may practice scalping, exiting their trades in a matter of a few minutes if they have achieved their profit target, but scalpers will always be in a position for much shorter than a traditional day trader.
Scalping vs. swing trading
Swing trading involves leaving your trades overnight and keeping them for a few days to some weeks, until the price swing, usually on the daily timeframe, plays out. Many swing traders don’t have time to keep watching the market all day, but those who have the time can scalp the market while still maintain their swing trades.