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Chapter 6- Explain the Day Trading Strategy Known as Scalping

Day traders have access to a variety of strategies; the one we will focus on in this article is known as Scalping. In the traders world scalping is in the category of "high frequency trading." A good scalp trader can make hundreds of trades daily. The following information will be invaluable for successful scalp trading.

The Theory behind Scalp Trading

Let’s first say that you'd be best served if you practiced this strategy offline before going live. Many trading platforms now allow the customer to trade offline until they feel confident to trade live. The only thing a scalp trader is trying to do is play between the bid/ask price. The pick-off is only a few cents, so scalp trades will take seconds or minutes, not much more.

Here's an example: Stock ABC has a bid price of 20 5/8, and a ask price of 20 3/4. The fraction on this is - 20.625 and 20.75, that's a .125 spread or twelve and a half cents. A scalp trader will try and buy 1000 shares at 20.68 and sell them at 20.71, making a profit of three cents, or $30.00 on the trade.

Pros: Better control, quick profits, limits risk, no positions open overnight.

Cons: More expenses (commissions, tools), requires margin account.

Tools

It's essential that you have access to stock charts and level II quotes. Since scalping involves trading in fractions, it would also be advisable to have a decimal/fraction chart available, or better yet memorize the common conversions.

Broker: You must have direct access to a broker. This means your broker must have instant execution for you to successfully scalp trade.

Stock Charts

The key to successful scalp trading is finding the right stocks to trade. Here are the three criteria for choosing the right stock:

1. You need a stock with high daily volume.

2. You need a stock that's stable - doesn't have wild price fluctuations.

3. You need a fairly tight bid/ask spread.

One stock you can model your selections by is GE (General Electric). Scalpers trade this stock all day long; it fits the three step criteria. GE is just an example; you will find many more stocks that will fit your trading needs.

Level II Quotes

This is a tool scalp traders use to look at block size and prices of trades in the system. This quote system is sort of the trades behind the prices you see on the stock ticker. You have to remember that there are people out there trying to do the same thing you are, and they also have access to the tools we're discussing here. That being said, level II quotes are useful in seeing what orders are out there and how they stack up on the bid and ask sides.

Setting-Up a Trade

There are a few strategies for scalping, but we will stick to the most common.

Traditional Scalp: As mentioned, you'll need a high volume, small price movement stock to execute this trade. Since all we have is history to predict the future, a one minute stock chart will be used. The stock you selected for trading should trade in a tight range, and this will be best reflected in your daily chart. Once this range is established, you will start observing the one minute chart for momentum movement. As the stock moves to the bottom of the range, be prepared to execute the trade. These trades need to be made in blocks of 1000 or higher. You have to remember that there is a commission on each trade.

Risk/Reward Ratio: You must adhere to some strict rules, and having an exit strategy is one of them. Most experts suggest a 1:1 ratio. What this means is: if your anticipated profit is ten cents, then you must put a loss limit at ten cents. The example here is: You bought 1000 shares at $20.00. You have a stop loss order in place for 1000 shares at $19.90. You also have a sell order at $20.10. These are called "simultaneous orders," one cancels the other when one is executed. You can do this manually, but it limits you if you want to trade several stocks at once.

The other form of scalp trading is known as "inside the box." It's really tough because you are going against professional market makers, and it can be more frustrating than profitable. You're attempting to take inside positions against the bid/ask prices. You're buying at a discount and selling at a premium - very hard to beat the pros.

Your limited risk and more frequent price moves make scalp trading very popular with day traders. Do yourself a favor, practice offline and learn how to use the tools so it becomes second nature - this will give you the best chance at being a successful scalp trader.