The scalping day trading strategy is one where the traders open very short-term trades and exit with a small amount of profit. By opening many such trades, the traders are able to make good profits in every trading day. Unlike swing and long-term traders, scalpers are never interested in the macro themes going on in the market. Instead, they are interested in the current chart pattern and how it will move within the next five minutes. The approach also relies on the idea of lower exposure to risk since the timeframe of the trades is usually very minimal. In this article, we will look at the scalping strategy, its advantages, disadvantages, the various ways you can use it, and how to manage your risk.
Why Use Scalping Strategy?
There are several reasons why scalping strategy makes sense to many traders.
No need to understand the macro environment. In scalping, you don’t need to spend time reading and analyzing the local and global macro environment.
Removes the time factor of trading. Because the trades are open for just a few minutes, you don’t have the common overnight risks.
Immediate change of mind. With scalping, you can change your mind, close the trade, and open a new one within minutes.
No in-depth research required. In other forex trading strategies, it is important to have a good understanding of the two economies. In scalping, all this research is unnecessary.
You can take advantage of immediate swings. With scalping, you can enter a trade exactly when there is a sudden spike and exit it as soon as the market stabilizes.
Drawbacks of Scalping Strategy
As with all trading strategies, scalping has its own challenges as well. Some of these drawbacks are:
High account minimum. Some brokers require a high account minimum for traders using the scalping strategy. This could be as high as $25,000.
High transaction costs. Scalping strategy requires opening of many trades per day. While the costs of opening each trade is usually very little, they can add up when you open many trades per day.
Overtrading. Experts have always warned about the risks of overtrading. A good example of such warnings was issued by Alexander Elder, in his book, come to my trading room. This is a must-read book for anyone interested in trading.
Missing long-term gains. When you focus on very short-term trades, you can miss the long-term gains in a currency pair.
Emotions. Emotions can run high when you make trades within minutes of each other. It takes a very hardened mind to not get caught up in the emotions of euphoria, depression and anxiety that come along with fast paced trading.
How to Use the Scalping Day Trading Strategy
When using the scalping strategy, there are three primary steps you need to follow.
- Find the currency pairs. In this step, you should scan the chart formation of the currency pairs that you want to trade. Your goal is to identify pairs that are trending and not consolidating.
- Set-up the charts. Here, you should set-up the charts to ensure that the timeframe does not exceed 5 minutes. It is not recommended to use a chart that has a longer timeframe when using the scalping strategy.
- Use your strategy. After identifying the pairs you want to trade and setting up the charts, you should apply your preferred strategy to trade.
While there are many scalping strategies you can use, we will look at five of the most common ones. These are:
Following the trend
The channel strategy (support and resistance)
Channel breakout strategy
Combining a trend indicator (ADX) and an oscillator (RSI).
Following the trend
The most common scalping strategy is that of following the trend. A trend is defined as a period when a currency pair is moving in an upward or downward trend over a certain period.
The basic idea is to buy when a currency pair is showing signs of a strong upward trend and shorting when it is showing signs of a strong downward trend. After entering the buy or sell trade, the scalper should exit after making a small profit to avoid being caught up in a reversal.
In his book on trend following, Michael Covel equated it to the Newton’s law of motion, which says that an object in motion will remain in a straight line unless acted upon by an unbalanced force. In the book, he also warned against the risks of trading against the overall trend.
A good example of this is shown on the 5-minute AUD/USD chart shown below. The pair formed a double bottom pattern at the 0.6806 level and the started moving up. It then crossed two important resistance levels, which are shown in blue and white. Therefore, since it appears that there was a strong upward trend, a scalper could have bought the pair at 0.6815 level and a take profit at the 0.6818 level. This level was an important resistance level as you can see below.
With this approach, technical indicators are not necessary. All you need to do is to identify a strong trend, buy the pair, and then put a take-profit a few pips above it. The take-profit should be close to the purchase price because your goal is not to ride the entire trend. Instead, you want to make a small profit and you don’t want to be caught in a reversal.
A common risk in trend following is that a reversal can happen at any time. To stay safe, it is recommended that you use a stop loss, which will stop your trade with a loss if the trend changes suddenly. Another risk is that of exiting a trade when the trend is not done yet. The lost opportunity is a risk you need to avoid.
Channel or support and resistance strategy
Another scalping strategy you can use is the channel strategy. A channel is created when the currency pair is struggling to break-out past a support and resistance. A support is a floor in which the pair struggles to cross while the resistance level is the ceiling. The channel can move upwards, downwards, or in a sideways direction. There are two steps to follow when using the channel strategy.
1. Look at the chart and find areas where the pair is struggling to cross.
2. Use the trend line tool in MT4 to join the support and resistance areas. You can also use the equidistance tool.
3. Buy the currency pair when it touches the support level and put a take profit slightly below the resistance level.
4. Sell the pair when it touches the resistance level and have a take profit slightly above the support level.
5. To avoid being caught in a false breakout, stop the trades after the third cycle.
A good example of the support and resistance strategy is shown on the five-minute AUD/USD pair shown below. After drawing the support and resistance channel, the trader could have shorted the pair as shown using the blue arrows and bought the pair when it started moving upwards.
This strategy has proven effective for many years. However, the challenge has always been on how to identify when a breakout is about to happen. While there is no written rule about this, the ideal situation is to use stop losses and take profits to avoid being caught in a false breakout.
As with the previous strategy, this one does not require having the technical indicators.
Channel Breakout Strategy
In the previous example, we looked at how to use the channel strategy when trading. Another similar scalping strategy is to trade when a breakout happens. This is because all channels end up in a breakout in either direction. There are several methods of using the strategy. In this example, we will look at how you can use the double EMA to spot when there is a breakout.
1. Create a channel by using the trendlines or the equidistance tool.
2. Apply a long and short EMA on the chart. The most common periods used are 7 and 14. Still, you can test with other timeframes as well.
3. Wait for the price to cross the support and resistant line. If the two EMAs cross one another, it could be a sign that the new trend will prevail.
A good example of this is shown on the AUD/USD pair shown above. After the pair broke-out, the two EMAs made a crossover, and the pair moved higher, which was a sign that the pair could continue moving upwards.
While the strategy works well, the biggest challenge is that of a false breakout. To reduce the risks, you should wait a bit to see whether the pair is indeed moving in the direction of the trend. Then, you should place a trade and place a tight take profit.
Relative Strength Index and ADX
Another common scalping trading strategy is that of combining the Relative Strength Index (RSI) and the Average Directional Movement Index (ADX). The RSI is an oscillator, which means that it varies over time within a band. It is a leading type of indicator. The ADX on the other hand is a trending indicator. This means that it is a lagging type of indicator. When the two are combined, it becomes very easy to identify good entry and exit points. To use this strategy, you need to follow these steps.
1. Identify a currency pair that is moving in an upward or downward trend.
2. Add the RSI. As you develop your strategy, you should test the various periods and see the one that suits your strategy.
3. Add the ADX indicator. This is used to measure the strength of the trend.
A good example of this is shown on the AUD/USD pair below. The new trend starts to form when the RSI is at the oversold level. Therefore, you can place a buy trade when the RSI passes the oversold level and hold it for a few minutes. In all this, the ADX is used to measure the strength of the trend. If it starts weakening, it might be an indication that the strength of the trend is waning.
How to Succeed Using the Scalping Strategy
To succeed using the scalping strategy, you need to do three things. First, you need to have a good strategy. While the strategies discussed here are common, you can create your own strategy as well. You can also use other strategies like candlestick patterns that have not been discussed here. If you are just starting your trading journey, we recommend that you spend a few months creating and testing the strategy.
Second, we recommend that you mitigate your risk for all trades that you initiate. There are a few ways you can achieve this. For example, you can use minimal amount of leverage on your trading. Also, you can open trades with small lot sizes. While the profits you generate will be lower, the risks you expose yourself to will be minimum.
Third, you should always have a stop loss for all your trades. A stop loss protects your account when the trade goes in the opposite direction. A stop loss should be in line with your risk profile. Beginners are always recommended not to risk more than 2% per trade.
Finally, you should take time to learn about the psychology of trading especially when you are a new trader. This is a good thing because your mental status can determine how successful you are. It will also help you prepare for any eventuality on your trades.
Final Thoughts on Scalping
Unknown to many, the scalping strategy is very common these days. It is used by thousands of individual traders every day. Many institutional investors and hedge funds use it as well. Some of the most common users of the strategy are large quantitative and algorithmic traders. To succeed, you will need to come up with a good strategy, test it, and use the proper risk management approaches.