The Ins and Outs of Forex Scalping

What Is Forex Scalping?

In the investment world, scalping is a term used to denote the "skimming" of small profits on a regular basis, by going in and out of positions several times per day.

Scalping in the forex market involves trading currencies based on a set of real-time analysis. The purpose of scalping is to make a profit by buying or selling currencies and holding the position for a very short time and closing it for a small profit. Many trades are placed throughout the trading day using a system that is usually based on a set of signals derived from technical analysis charting tools. The charting is made up of a multitude of signals, that create a buy or sell decision when they point in the same direction.

A forex scalper looks for a large number of trades for a small profit each time.

How Forex Scalping Works

Scalping is not unlike day trading in which a trader will open a position and then close it again during the current trading session, never carrying a position into another trading period or holding a position overnight. However, while a day trader may look to take a position once or twice, or even a few times a day, scalping is much more frenetic and will trade multiple times during a session.

Whereas a day trader may trade off five- and 30-minute charts, scalpers often trade off of tick charts and one-minute charts. In particular, some scalpers like to try to catch the high-velocity moves that happen around the time of the release of economic data and news. Such news includes the announcement of the employment statistics or GDP figures—whatever is high on the trader's economic agenda.

Scalpers like to try and scalp between five and 10 pips from each trade they make and to repeat this process over and over throughout the day. Pip is short for "percentage in point" and is the smallest exchange price movement a currency pair can take. Using high leverage and making trades with just a few pips profit at a time can add up. Scalpers get the best results if their trades are profitable and can be repeated many times over the course of the day.

Remember, with one standard lot, the average value of a pip is about $10. So, for every five pips of profit made, the trader can make $50 at a time. Ten times a day, this would equal $500.

Scalping Personality

Scalping, though, is not for everybody. You have to have the temperament for this risky process. Scalpers need to love sitting in front of their computers for the entire session, and they need to enjoy the intense concentration that it takes. You cannot take your eye off the ball when you are trying to scalp a small move, such as five pips at a time.

Even if you think you have the temperament to sit in front of the computer all day—or all night if you are an insomniac—you must be the kind of person who can react very quickly without analyzing your every move. There is no time to think. Being able to "pull the trigger" is a necessary key quality for a scalper. This is especially true in order to cut a position if it should move against you by even two or three pips.

Market-Making vs. Scalping

Scalping is somewhat similar to market-making. When a market maker buys a position they are immediately seeking to offset that position and capture the spread. This form of market-making is not referring to those bank traders who take proprietary positions for the bank.

The difference between a market maker and a scalper, though, is very important to understand. A market maker earns the spread, while a scalper pays the spread. So when a scalper buys on the ask and sells on the bid, they have to wait for the market to move enough to cover the spread they have just paid. In the converse, the market maker sells on the ask and buys on the bid, thus immediately gaining a pip or two as profit for making the market.

Although they are both seeking to be in and out of positions very quickly and very often, the risk of a market maker compared with a scalper, is much lower. Market makers love scalpers because they trade often and they pay the spread, which means that the more the scalper trades, the more the market maker will earn the one or two pips from the spread.

How to Set up for Scalping

Setting up to be a scalper requires that you have very good, reliable access to the market makers with a platform that allows for very fast buying or selling. Usually, the platform will have a buy button and a sell button for each of the currency pairs so that all the trader has to do is hit the appropriate button to either enter or exit a position. In liquid markets, the execution can take place in a fraction of a second.

Picking a Broker

Remember that the forex market is an international market and is largely unregulated, although efforts are being made by governments and the industry to introduce legislation that would regulate over-the-counter (OTC) forex trading to a certain degree.

As a trader, it is up to you to research and understand the broker agreement and just what your responsibilities would be and just what responsibilities the broker has. You must pay attention to how much margin is required and what the broker will do if positions go against you, which might even mean an automatic liquidation of your account if you are too highly leveraged. Ask questions to the broker's representative and make sure you hold onto the agreement documents. Read the small print.

The Broker's Platform

As a scalper, you must become very familiar with the trading platform that your broker is offering. Different brokers may offer different platforms, therefore you should always open a practice account and practice with the platform until you are completely comfortable using it. Since you intend to scalp the markets, there is absolutely no room for error in using your platform.

If you press the "Sell" button by mistake, when you meant to hit the buy button, you could get lucky if the market immediately goes south so that you profit from your mistake, but if you are not so lucky you will have just entered a position opposite to what you intended. Mistakes like these can be very costly. Platform mistakes and carelessness can and will cause losses. Practice using the platform before you commit real money to the trade.

Liquidity

As a scalper, you only want to trade the most liquid markets. These markets are usually in the major currency pairs, such as EUR/USD or USD/JPY. Also, depending on the currency pair, certain sessions may be much more liquid than others. Even though the forex markets are trading for 24 hours a day, the volume is not the same at all times of the day.

Usually, when London opens at around 3 AM EST, volume picks up as London is the major trading center for forex trading. At 8 AM EST, New York opens and adds to the volume being traded. Thus, when two of the major forex centers are trading, this is usually the best time for liquidity. The Sydney and Tokyo markets are the other major volume drivers.

Guaranteed Executions

Scalpers need to be sure that their trades will be executed at the levels they intend. Therefore, be sure to understand the trading terms of your broker. Some brokers might limit their execution guarantees to times when the markets are not moving fast. Others may not provide any form of execution guarantee at all.

Placing an order at a certain level and having it executed a few pips away from where you intended, is called "slippage." As a scalper you cannot afford slippage in addition to the spread, so you must make sure your order can and will be executed at the order level you request.

Redundancy

Redundancy is the practice of insuring yourself against catastrophe. By redundancy in trading jargon, I mean having the ability to enter and exit trades in more than one way. Be sure your internet connection is as fast as possible. Know what you will do if the internet goes down. Do you have a phone number direct to a dealing desk and how fast can you get through and identify yourself? All these factors become really important when you are in a position and need to get out quickly or make a change.

Choosing a Charting Time Frame

In order to execute trades over and over again, you will need to have a system that you can follow almost automatically. Since scalping doesn't give you time for an in-depth analysis, you must have a system that you can use repeatedly with a fair level of confidence. As a scalper, you will need very short-term charts, such as tick charts, or one- or two-minute charts, and perhaps a five-minute chart.

Preparing to Scalp

1. Get a Sense of Direction

It is always helpful to trade with the trend, at least if you are a beginner scalper. To discover the trend, set up a weekly and a daily time chart and insert trend lines, Fibonacci levels, and moving averages. These are your "lines in the sand," so to speak, and will represent support and resistance areas. If your charts show the trend to be in an upward bias (the prices are sloping from the bottom left of your chart to the top right), then you will want to buy at all the support levels should they be reached.

On the other hand, if the prices are sloping from the top left down to the bottom right of your chart, then look to sell each time the price gets to a resistance level. Depending on the frequency of your trades, different types of charts and moving averages can be utilized to help you determine direction.

The daily chart shows the price has reached the 127.6 Fibonacci extensions, at about 1.3975. Clearly, there is a possibility of a pullback to the trend line somewhere in the vicinity of 1.3850. As a scalper, you can take the short side of this trade as soon as your shorter-term charts confirm an entry signal.

In the example above, the weekly chart shows a strong upward bias of the EUR/USD. The price could be heading back to a target of 1.4280, the previous high on November 4, 2010.

2. Prepare Your Trading Charts

A forex scalping system can be either manual, where the trader looks for signals and interprets whether to buy or sell; or automated, where the trader "teaches" the software what signals to look for and how to interpret them. The timely nature of technical analysis makes real-time charts the tool of choice for forex scalpers.

Set up a 10-minute and a one-minute chart. Use the 10-minute chart to get a sense of where the market is trading currently, and use the one-minute chart to actually enter and exit your trades. Be sure to set up your platform so that you can toggle between the time frames.

Trading System

In the system shown here, and there are many other systems you can use to trade profitably, we've included a three-period RSI with the plot guides set to 90% and 10%. Only trades on the short side once the RSI crosses over the 90% plot guide, and the long side once the RSI reaches below the 10% plot guide, are entered. To nuance the signal, it's best to wait for the 2nd crossing into either of the two zones (only take the trade if the RSI goes into the zone—either the 10% for longs or 90% for shorts—on the second consecutive attempt.

Now, before you follow the above system, test it using a practice account and keep a record of all the winning trades you make and of all your losing trades. Most often it is the way that you manage your trades that will make you a profitable trader, rather than mechanically relying on the system itself.

In other words, stop your losses quickly and take your profits when you have your seven to 10 pips. This is a scalping method and is not intended to hold positions through pullbacks. If you find that you can manage the system, and you have the ability to pull the trigger quickly, you may be able to repeat the process many times over in one trading session and earn a decent return.

Remember that too much analysis will cause paralysis. Therefore, practice the methodology until it is automatic for you, and even boring because it becomes so repetitive. You are in the business of scalping to make a profit, not to boost your adrenalin or feel like you are playing in a casino. Professional traders are not gamblers; they are speculators who know how to calculate the risk, wait for the odds to be in their favor, and manage their emotions.

When to Scalp and When Not to Scalp

Remember, scalping is high-speed trading and therefore requires lots of liquidity to ensure quick execution of trades. Only trade the major currencies where the liquidity is highest, and only when the volume is very high, such as when both London and New York are trading. The unique aspect of trading forex is that individual investors can compete with large hedge funds and banks—they just need to set up the right account.

Do not scalp if you do not feel focused for whatever reason. Late nights, flu symptoms, and so on, will often take you off your game. Stop trading if you have a string of losses and give yourself time to regroup. Do not try to get revenge on the market. Scalping can be fun and challenging, but it can also be stressful and tiring. You must be sure that you have the personality to indulge in high-speed trading. You will learn a lot from scalping, and then by slowing down, you may find that you can even become a day trader or a swing trader because of the confidence and practice you may get from scalping. Remember though, scalping is not for everyone.

Always keep a log of your trades. Use screen capture to record your trades and then print them out for your journal. It will teach you a great deal about trading and even more about yourself as a trader.

The Bottom Line

The forex market is large and liquid; it is thought that technical analysis is a viable strategy for trading in this market. It can also be assumed that scalping might be a viable strategy for the retail forex trader. It is important to note, however, that the forex scalper usually requires a larger deposit, to be able to handle the amount of leverage they must take on to make the short and small trades worthwhile.

Scalping is very fast-paced. If you like the action and like to focus on one- or two-minute charts, then scalping may be for you. If you have the temperament to react quickly and have no compunction in taking very quick losses, not more than two or three pips, then scalping may be for you.

But if you like to analyze and think through each decision you make, perhaps you are not suited to scalp trading.