Many new traders are attracted to the financial market because they have heard or read about day trading or short-term scalping. Some traders actively promote scalping strategies as the most profitable ones when it comes to trading the foreign exchange markets. It is important that you understand what scalping actually is and some of the problems it can create. By the end of this article, you should have a pretty good idea of whether this style of trading suits your personality.
What scalping strategies exist in Forex?
There are several basic trading methods that can be applied in the financial markets. These include position trading, swing trading, day trading and scalping. All of them more or less relate to the average time of holding a position. Position traders are typically long-term traders who focus on holding positions for months or even years. Swing traders tend to be medium-term traders with an average holding time of between a week and a month or so.
Day traders typically open and close positions within the same trading session. They like to keep their positions open for an hour to several hours. Scalpers are generally short-term traders. They seek to profit from minor price movements that can last from a few minutes to half an hour. One of the most successful types of traders specializing in the short-term scalping arena are high-frequency trading companies.
A large percentage of traders who specialize in scalping are usually algorithmic traders. They use computerized algorithms to place their orders on the market. This helps them achieve maximum efficiency and speed, which is extremely important in the world of short-term trading.
These algorithms often give systems traders an additional advantage over their discretionary counterparts, whose decision-making processes will lag behind the robots. However, scalping is not the exclusive domain of algorithmic traders, but it is important to remember that they usually have a big advantage when it comes to identifying short-term advantages in the market.
That being said, there are certain techniques that a discretionary scalper can use that will not directly compete with high frequency companies. We’ll look at some of these techniques.
A typical example of assessing risk for scalping rewards might look like this:
- risk 10 pips to gain 10 pips
- risk five pips to get 10 pips
- risk 10 pips to get five pips
These are just a few very simple examples, but they should give you some idea of the types of trades a typical scalper might be looking for in the market.
How to scalp on Forex?
Now that you have a basic understanding of how scalping works, let’s dive deeper into learning the mechanics of scalping. Scalper traders tend to gravitate towards time frames such as one, three and five minutes.
These timeframes will tend to offer enough volatility to take advantage of short-term price movements. Sometimes traders use a combination of these time frames as part of their overall trading strategy. For example, a scalper might look at a five-minute time frame to assess the overall market trend and then switch to a one-minute time frame to execute his trade setups.
As with any trading style, a trader scalping the market must have a clearly defined trading plan. One of the most popular scalping methodologies involves the use of technical indicators. Trading indicators such as ADX, Stochastic, Momentum and RSI can provide the scalper with the pattern needed to find trade setups.
Additionally, some traders prefer a trading strategy based solely on price action. This form of analysis will involve relying on support and resistance levels, supply and demand zones, candlestick patterns, chart patterns, and other price analysis techniques to find trading opportunities.
Due to the short-term nature of scalping techniques, which can result in high turnover and trading volume, it is necessary that scalpers do everything possible to manage their transaction costs, primarily in the form of bid-ask spreads. The best broker model for forex scalpers is the ECN model.
Brokers operating on an ECN-based model offer the lowest spreads. These brokers will give you true market prices without any additional markups. However, you will have to pay a small commission associated with each trade. Even then, the costs will be significantly lower than traditional dealing desk brokers.
There are several trading platforms that are better suited for scalpers. You should do your due diligence and compare the different trading platforms available to you and choose the one that is compatible with short-term scalping.
Some of the most reputable execution platforms available for currency traders include:
- Metatrader
- Ninjatrader
- Tradestation
- Multicharts
Of these, Metatrader is the most popular among spot forex traders, while Ninjatrader is one of the more popular options among currency futures traders.
The best currency pairs for scalping
Deciding which currency pairs to trade is an important factor for all successful scalpers. There are several key characteristics that you should analyze for each potential match.
The first is the average daily range of a currency pair, also called ADR. This indicator tells us what the average high to low range is for a particular financial instrument. The larger the ADR, the higher the range, meaning the currency pair has a relatively good level of volatility, which is important for short-term profits.
Another important consideration is average trading volume. This can be a difficult analysis factor to collect data because the spot foreign exchange market does not have a centralized trading exchange. However, there is enough historical data that tells us which currency pairs are the most traded and liquid.
And these are traditionally the major currency pairs in which the US dollar is traded against the currency pair of another major country or region. For example, EURUSD, GBPUSD, USDCAD, USDJPY, USDCHF and AUDUSD are considered major currency pairs and have significant trading volumes behind them.
Of these currency pairs, EURUSD is by far the most traded currency pair in the world, followed by USDJPY and GBPUSD. EURUSD accounts for approximately a quarter of all currency trading. USDJPY accounts for about 13% of all currency trading transactions, and GBPUSD accounts for about 10% of all trading order flow.
While all three of them are generally excellent choices for scalping in the forex market, EURUSD and GBPUSD are two of the best currency pairs for scalpers. Both offer a relatively large average daily range combined with very tight bid-ask spreads and excellent liquidity and volume characteristics. The best scalping strategies usually involve one of these major currency pairs.
Below you will find the latest hourly and daily volatility data for the EURUSD pair. The chart shows that at the time of writing this article, the average daily volatility for EURUSD is around 80 pips.
Price action scalping strategies
Let’s build a simple scalping strategy for the foreign exchange market. The strategy we are about to describe can be used in both the spot forex market and the currency futures market. You can trade this particular strategy on any major currency pair, however it works best on EURUSD, GBPUSD or USDJPY. As mentioned earlier, these three currency pairs have many characteristics that fit into a viable scalping methodology.
Our scalping model will be a fairly simple method based on price action. We will look for a breakout of the horizontal resistance level in case of a long trade. Likewise, we will watch for a breakout of the horizontal support level in the event of a short trade.
In case of a bullish breakout, the breakout candle should be a bullish maribozu candle. And in case of a bearish breakout, the breakout candle should be a bearish marubozu candle. If you are not familiar with the maribozu candlestick pattern, it is a single bar candlestick pattern that opens at one end of a range and closes at the opposite end of the range.
The essence of the maribozu candle is that it indicates strength. Thus, when there is a breakout to the upside, that is, on a bullish marubozu candle, it provides additional confirmation for a bullish trade. Likewise, when there is a breakout to the downside, i.e. a bearish maribozu candle, it provides further confirmation for a bearish trade.
Once these two conditions are met, we will wait for the price to pull back to retest the broken horizontal price level. When prices approach this level after a breakout to the upside, the old resistance level will act as new support. Likewise, when prices approach this level after breaking down, the old support level will act as new resistance. This is an important trading concept that we will incorporate into our trading strategy.
The entry signal for a long setup will occur when the price moves one pip above the candle that touched the new support level on a pullback below. The stop loss will be placed just below the same candle. Regarding the take profit target, we will use a simple 2:1 risk criterion.
The signal to enter a short position will be triggered when the price moves one point below the candle that touched the new resistance level on a pullback higher. The stop loss will also be placed just above the same candle. The signal to exit a trade at a profit will be set using a reward to risk ratio of 2X to 1X.
Below you will find a five-minute chart for the EUR/USD pair.
The very first thing we need to look for is a potential resistance level. If we move to the far left of the price chart, we can see that the price has begun to consolidate. We see a resistance level that has formed during this minor consolidation phase. At this point we will watch the price action closely and see if we can spot a breakout from this level to the upside. Specifically, we want the bullish Marubozu candle to be a breakout candle.
Shortly after prices begin to move higher towards the resistance level, we may find a strong wide range candle that closes above the resistance level. In fact, this breakout candle is a bullish Marubozu candle that confirms our long trade setup. But keep in mind that this event only serves as confirmation that there is a potential long-term opportunity. The price will have to pull back to this level for a real trade to open.
After the bullish breakout, we can say that prices continued to rise for a few more candles before they declined and the consolidation phase began again. As prices consolidated in a downward move, they eventually reached the initial breakout point. You can see where this happened by looking at the candle inside the green circle. If you study candlestick analysis, you will also recognize this candlestick pattern. This is considered a bullish hammer formation, also called a bullish pin bar formation.
Now that the price has touched the resistance level as new support, we will use this candle as our entry point into the market. Keep in mind that we will need to wait for the price to move at least one pip above this candle for the long entry signal to be triggered.
The stop loss will be placed here just below the low of the pin bar. Our profit taking level will be based on a two to one risk to reward ratio.
Let’s look at the bearish variation of this scalping strategy pattern.
The initial part of our analysis will require us to plot a horizontal support level. Notice the two swing lows on the left side of the price chart, which we used as a guide to draw the horizontal line.
Prices traded within a well-defined range leading to a breakout below support. We can confirm that the breakout candle is a bearish Marubozu candle.
Now all we need to do is wait for a pullback to the previous support level, which should act as new resistance. A few bars after the bearish breakout, prices began to roll back to the old level. The price touched new resistance and slightly broke through this area. You will find a candle that serves as a signal to open a position. Once the price moves one pip below the low of this candle, we can go short.
The third candle following the signal candle triggered our entry into a short position. The stop loss will be placed above the high of the signal candle, which can be seen by the black dotted line above the entry. The target for this trade will be achieved when the price reaches 2:1 profit to risk level. The 2X RVR target is shown as a green dotted line at the bottom of the graph.
Scalping as a way to make money from trading
Is it possible to make a living by scalping? This is a question that many novice traders who start trading Forex often ask themselves. The answer to this question is not always clear-cut. Of course, there are traders who make consistent profits by scalping the forex market, however, there are many more traders who have tried this and ended up losing their trading deposits.
There are several reasons why scalping has its difficulties and problems. First, due to the relatively high transaction costs associated with very short-term trading, there is a larger hurdle that must be overcome before you can experience positive results.
To illustrate this with a simple example, compare that a swing trader often has a target of 100 pips, while a scalper may only have a target of 10 pips of profit. If the bet spread on the currency pair being traded is, for example, two pips, then the cost of this transaction will be less than 2% of the swing trader’s potential profit, compared to 20% of the scalpers’ potential profit. So, when you add up this relatively higher cost over a long series of trades, transaction costs can eat up more than half of a trader’s gross profit.
The second disadvantage that scalpers face is the viability of trade setups on very small time frames. This means that trade setups that occur on higher time frames tend to be much more reliable than those that occur on smaller time frames such as one-minute, three-minute or five-minute.
For example, a breakout that occurs from a multi-week resistance level represents a trade setup with a much higher probability than a breakout that occurs from a multi-hour resistance level. Most back-and-forth price movements on lower time frames have little value in terms of price predictability due to the noisy nature of the market on lower time frames.
In any case, a trader who believes that they have a statistical edge in the market that can be consistently applied to the scalping methodology should demonstrate their strategy and become thoroughly familiar with the relevant return targets before risking their capital.
Let’s sum it up
As we have hopefully learned from this lesson, traders who use scalping strategies in the forex market must pay close attention to certain characteristics of the currency pairs being traded. For example, you should make sure that the currency pair is relatively liquid and provides good daily volatility.
Additionally, it is best to use scalping methods with regulated ECN brokers that offer the best spreads for buyers and sellers. While these characteristics are true even for swing traders, they are especially important for short-term day traders and scalpers.
You will need to constantly test and improve your trading technique to have the best chance of long-term success. Scalpers are always looking for new strategies that allow them to exploit price movements to make a profit. This is because many of the factors available on smaller time frames sometimes become less effective over time or disappear altogether.
Last but not least, you must be aware of the problems that short-term scalping creates and be prepared to address these disadvantages as part of your trading plan.
