Many traders rely on scalping as their bread and butter, especially in active markets. Forex scalping is made easier by mechanical trading systems, which empower independent traders to execute hundreds of trades each day.
Scalping is contrary to traditional “hold the winners and liquidate the losers” trading strategies, and successful scalping requires strict risk management. The key to survival lies in taking the right scalps and exiting from positions at precisely the right times.
I’ve found scalping to be fairly profitable, yet it requires plenty of patience and discipline. There are countless forex scalping strategies, and it will be helpful to review the foundational hows and whys of scalping before outlining several types of strategies used by successful scalpers.
What is scalping?
As most traders know, “scalping” refers to a family of trading strategies by which traders seek to earn profits from many small price movements instead of holding currency positions for long periods while following trends.
The scalper’s goal is to buy or sell at the optimal price, then quickly liquidate the position for profit of a few cents, or even less. Scalpers are willing to settle for small, frequent gains instead of holding on for the long term.
From a broader perspective, any kind of forex trade becomes a scalp when the trader takes profit at a level near the 1:1 risk-to-reward ratio. Likewise, the amount of the profit equals the amount of the stop dictated by the trade’s setup.
How forex scalpers earn their keep
Forex scalpers exploit short-term price trends, economic and political events, and also the internal dynamics of currency markets themselves. Many focus on the sudden, sharp price movements which move currency markets after news announcements.
Scalpers are usually more concerned with volatility than with trends or ranges. Successful traders in this niche are able to identify currencies in which temporary lack of liquidity creates trade opportunities through volatility.
For example, consider the EUR-USD currency pair. Usually, spreads are fairly tight, and the market is almost always liquid enough to prevent any significant gaps in bid-ask spreads. However, sometimes liquidity dries up. When this happens, it’s invariably because of political or economic news, but the specific cause itself isn’t important to a pure scalper.
In this example, when liquidity disappears the bid-ask spread widens. Let’s say the bid price is 1.4020 and the ask is 1.4060. As soon as the price moves up to 1.4040, and the spread has narrowed back toward its normal amount, the mechanical trading system sells short.
Then, as volatility carries the price lower, say to 1.4030, the trading system closes the short position and opens a long one. The scalper’s objective is to profit from the emotional reactions and volatility in the market by riding the slippage between bid and ask prices.
This type of trading is based on the idea that current price moves reflect short-term emotion rather than fundamental changes in trends. Gaps and breakouts from news are often exploited. Scalpers buy or sell just before the news is released, and then trade the brief, sharp swings for quick profits.
Other than strategies which involve breakout news, forex scalping is based on technical analysis rather than fundamental analysis. During the short time-frames used by scalpers, prices appear to move more randomly than they do during long-term trends.
There simply isn’t enough time for a trader to personally research the reasons behind each move. So, the most effective scalping strategies are always based on mechanical trading systems rather than manual trading.
Most scalpers use expert advisors (EA) to test and personalize scalping strategies. Then, mechanical trading systems are programmed to recognize and act on the appropriate technical indicators and scalpable price patterns.
The joys of scalping
Scalping is attractive for many reasons: First, shorter trade times mean reduced risk exposure on any given trade. And, since it’s most common for a currency price to move only a few pips at a time, small moves are easy to catch.
Also, small price moves occur even during range-bound sessions or quiet market periods, so forex scalpers can participate in any kind of market. Scalping is effective as both a primary and secondary trading method, and many traders use a combination of styles that incorporate scalping.
A “pure” forex scalper may trade hundreds of times per session using sub-minute time frames. Other traders on longer time frames often use scalping as a supplementary technique when markets are choppy or range-bound. On the shortest time frames, there are always plenty of exploitable opportunities for savvy traders.
Small profits can add up quickly
Successful scalping means winning more trades, while accepting a smaller gain from each winner.
A forex trader who is trading on trends or using other strategies based on longer time frames might win only half of his or her trades, or even less. The individual gains from each successful trade are expected to be larger than the individual losses, and the ratio of the number of winning trades compared to losers is expected to be fairly low.
In contrast, successful scalpers win a higher percentage of trades, yet their individual profits on those winners are approximately equal to or only slightly larger than their individual losses.
Speed is critical for scalping success
Because of the narrow spreads available in forex scalping, traders must complete multiple round-trip trades very quickly in order to be successful. Mechanical trading systems are ideal for automating the decision and execution processes, assuming the underlying strategies are viable.
Automated scalping systems can also instantly calculate, set and modify stop-loss and profit-taking orders, so traders can better focus on analytical and administrative tasks without missing sudden price moves.
Consistency is also important
Consistency in trading routines is especially important for successful forex scalping. Since scalping is based on the idea that gains from profitable trades will eventually outweigh losers, the size of each individual trade must be carefully chosen to avoid catastrophic drawdowns.
If position sizes are chosen erratically, then the laws of probability mean that eventually a single oversized, highly-leveraged losing trade will consume all the trader’s gains from many successful previous trades.
The best currency pairs for scalping
Every scalper has his or her own favorite currencies. Some currency pairs are easy and profitable to scalp, while others are too illiquid or have other issues. Generally, the very best currency pairs to be scalped are those which are either not subject to sharp movements, or in which such movements are relatively rare.
The best pairs for scalping are the “majors” such as EUR-USD, USD-CHF, and GBP-USD. Among those pairs the least volatile and most liquid is EUR-USD. It’s important to note that JPY (Japanese Yen) pairs are also considered major pairs, yet they behave somewhat differently; they’re discussed below regarding “carry pairs.”
For scalpers, the best characteristic of the majors is their liquidity, and their second-best quality is their relatively-subdued response to market shocks such as news events. A political event that moves the AUD-JPY pair by 100 pips may move the EUR-USD by only 30 pips, for example.
So, forex scalpers who like to trade range-bound currencies, or take advantage of relatively slow-moving currency pairs usually trade only the major pairs.
Carry pairs meet the scalper’s requirement for liquidity, yet they’re volatile. EUR-JPY and USD-JPY are called “carry pairs” because Japan’s perennially-low interest rates are attractive to institutions and large traders who borrow yen to finance other currency purchases.
During carry trades, the trader seeks to gain not only by currency price changes, but also by the yield which results from borrowing cheap yen that are later repaid using other currencies.
In effect, the trader is financing the trade by borrowing at low Japanese interest rates, and putting the loan to work in the currency of a country which offers higher interest rates.
Still, carry pairs are volatile because they react more strongly to market shocks, given their additional sensitivity to cross-border borrowing. For this reason, it’s far more difficult to scalp carry pairs.
As well, some specialist scalpers focus on “exotic” currencies such as the Russian Ruble, the NOK-USD (Norwegian Krone-U.S. Dollar), BRL-USD (Brazilian Real-U.S. Dollar) and many other lesser-known currencies. Due to volatility and liquidity issues, these currency pairs are generally only suitable for scalpers who carefully study the fundamental factors as well as technical indicators.
Types of forex scalping
Forex scalping may be divided into several general categories: Market-making, large order-small spread, and independent system-trading.
Market making is only practical for very large institutions and central banks. Market-makers may capitalize on spreads by simultaneously bidding and offering on both sides of the market. In contrast to speculative trading by small players, usually a market-maker’s objective is to support a national currency or promote a political or economic policy.
Large order-small spread forex scalping involves taking large currency positions, then liquidating them for gains following tiny price movements.
Of course, small independent traders comprise the third group of scalpers. These are the stereotypical scalpers who use a variety of strategies quickly enter and exit relatively small currency positions.
As described earlier, these scalpers close out their positions quickly as soon as their mechanical trading systems give an exit signal, generally near the 1:1 risk-reward level.
Forex scalping strategies
Although scalping is similar to other kinds of short-term strategies, there are particular scenarios in which scalping can be more profitable. Summarized below are several groups of scalping strategies.
News breakout scalping. The biggest and most common breakouts are news breakouts that occur after news releases. Regardless of the type of news being announced, volatility increases rapidly.
The initial movement is usually the strongest, and it’s often followed by subsequent smaller moves from the “aftershocks” of the news which can last several hours and offer plenty of scalping opportunities.
The cardinal rule of scalping news breakouts is to be out of the market during the very brief period leading up to the time of the news release, unless the trader is using fully automated trading tools and is highly experienced.
During this chaotic yet brief period, the widening of the spread makes trading more risky. Instead of jumping in “pre-news,” savvy forex scalpers use this brief period before the announcement to quickly research the fundamental basis for the news, identify the likely direction of the market post-news, and confirm the technical trading parameters.
Technical range breakout scalping. Some forex traders focus on scalping ranging markets during technical breakouts. A breakout is said to be “technical” when it isn’t directly related to a new announcement.
Technical breakouts occur when prices reach certain price levels at which a flood of buy or sell orders, especially from institutions and other large traders, causes prices to move very quickly outside the ranges in which they had been trading.
Scalping technical breakouts requires a different approach than that used for news breakouts. Traders should scalp technical breakouts more conservatively, by reducing leverage and position size, and by tightening stops. This is because (lacking news) there is no clear cause for the move, so traders are less certain of the eventual direction of the price.
Trend scalping. Scalping during a strongly-trending market is much different from scalping a range-bound market. During a trend, it’s critically important to ensure that the scalp trade follows the current underlying trend.
Trading against a trend can be especially risky because of the chance of sudden reversals. Scalping a counter-trend is possible, but since the majority of traders follow the market, it’s much less common.
Some successful forex traders use Fibonacci extensions for trend-following scalping. Fibonacci extension indicators help identify the current trend, as well as showing levels where prices may reverse.
When using Fibonacci extensions for mechanical trading, the scalper buys and sells when the price is at the support and resistance levels. As long as the trend continues, the system scalps repeatedly between the extension levels.
When the price returns to support/resistance as indicated by the extension levels, the system exits the trade and stays out of the market.
One supplemental scalping method used by longer time-frame forex traders is the “umbrella” scalping method. This technique lets traders improve the cost basis of positions upon entry, and then maximize profits on winning trades.
To execute an “umbrella” scalp, the trader first opens a currency position using his or her standard longer time-frame trading strategy. While holding the primary trade, the trader’s mechanical trading system identifies potential new trade setups in the same currency yet based on a shorter time-frame, while still in the same direction as the primary trade.
Umbrella scalping can be used in conjunction with most forex trading strategies, yet the complexity of managing the different trades is best left to mechanical trading systems. When used as a complementary technique, umbrella scalping may be considered as a form of risk management, since it has the effect of cost-averaging the entry prices achieved by the primary strategy.
In conclusion, scalping can be fun and profitable if you’re disciplined, patient, and well-equipped with the right trading system. There are plenty of opportunities to win, regardless of long term market trends.
Are you a scalper?