A scalping strategy employes a very short holding period for positions. All day trading takes place over relatively short time frames compared to others in the investment world (generally less than a day) but scalping is the strategy with the shortest holding period.
Scalping involves taking very small profits many times a day, or by catching a very small price movement with very large quantities of shares. The holding period for a scalper may be as little as a second, and is not generally more than a few minutes. A scalping strategy may involve simply trying to catch as small as a 1 penny change in a stock’s price, and can be as simple as getting orders executed on both the bid and offer of a stock without the stock’s price even moving. This is known as “taking the spread”. Scalpers use anywhere from 100 shares (1 round lot) to tens of thousands or possibly even more shares, depending on the available liquidity in a given stock or security. If a stock is very liquid (there are many buyers and sellers offering a large amount of shares) it generally supports larger positions because a large position in a less liquid security would risk a large price impact to exit the security.
A common scalping strategy today is employed by high frequency traders (also known as HFTs). These HFTs are highly sophisticated computer algorithms designed to be the fastest to post and remove liquidity on a stock’s book, and because of their super high speed they are able to get beneficial order fills much faster than a human can operate. These firms work so quickly that they can often respond to changing conditions faster can a human eye can even visually process the information.
The HFTs use their extremely fast speeds to take thousands of small positions every day across hundreds of stock symbols, often times taking even fractions of a penny as profit. The idea is that these small margins add up to big profit at the end of the day. As competition has increased in this niche HFT firms are finding it harder to reap the huge profits they once did. Many institutional players such as mutual funds have adopted the same algorithmic execution strategies of HFTs as well so it has become harder for these HFT scalpers to find the opportunity they once had. There are some indications that as volume increases HFT profits may return to previously high levels.
Humans can still employ scalping strategies as hand traders, but to be profitable it is necessary to use more sophisticated tools than are typically offered by retail brokerages, such as mid-point execution and ultra high speed data feeds. Humans must also pick their spots carefully as there is unlikely to be scalping opportunity present 100% of the day in a given security. A human scalper can even use HFT firms to his advantage if he understands where the opportunity to use these firms is. For example, having access to act as a trading partner to the market making HFT firms can give a trader much better execution than might be available on the LIT markets. The best execution with these transactions often takes place in the dark pools.
Using dark pools a human scalper can even get better execution on the bid and offer than would be available with LIT markets and “take the spread” himself, and doing this a few times with large enough size can become very profitable.
Some scalping strategies may involve watching for areas of support and resistance and using these areas as entries, assuming they will continue to hold or to enter a position as the price breaks a support or resistance level and catching the very short momentum push (created in part by HFT firms) that may occur as the price level breaks.
A scalper will always be watching what is known as the consolidated tape of a stock, which is the collection of prints showing every transaction that takes place. Combined with the stock’s book, which is every share posted to buy or sell on all ECN markets, this will give the trader a read on which direction the stock will go, as well as which markets are printing, and possibly even if a large institutional buyer or seller is transacting. This may provide an opportunity to piggyback on the price movement caused by an institutional player.
To be profitable it is essential that a scalper trade with a very specific set of tools, so brokerage choice is very important. Direct market access to the exchange of a trader’s choice is essential, because they must have the ability to find the most liquid market. Even a half penny of price improvement can mean big profits to a scalper, so the ability to find liquidity with dark pools and market making desks can be the difference between being profitable or not. Dark pools can also offer execution at the mid point of the spread, which executes between the bid and offer. This can offer a large price improvement when employed many times. Dark pools can also offer better and cheaper liquidity than may be posted on the LIT markets.
Scalpers must also watch every print that takes place for a stock, so having a professional data feed is a necessity as well as having good charting software. Always trade with a brokerage offering up to the moment data feeds, because opportunity does not exist for long in the HFT market environment and if your data is slow you will not be in a good place to capitalize on it.
A scalper also works with very thin margins, so it is essential to lower costs as much as possible. Trade with the lowest cost broker you can, preferably with a broker that will pass through rebates to you from ECN markets. Sometimes a scalper can make money without even having the price of a stock move, if they have the ability to collect rebates simply for transacting shares. A trader also must look for a brokerage that offers low priced access to dark pool trading, because rates can vary across firms. If a scalper does not trade with a broker offering rebates they should make all efforts to limit their trading costs.
A successful scalper will be very diligent and methodical in the way they extract profits from the market, and like all traders they must control risk. There are also so many computer algorithms operating with scalping strategies that learning how they behave in each individual stock and how to use them to your advantage is essential. Scalping can be a very reliable way to make profits from the market, but a scalper must develop and stick to his or her strategy 100% of the time to maintain their small margin of profit.