Last Updated on November 25, 2020 by Oddmund Groette
We don’t recommend scalping. Scalping involves competing with better-equipped traders and institutions, you need to deal with lots of randomness, and you most likely end up both wasting your time and money. There are better opportunities in longer time frames. Additionally, backtesting is more difficult the shorter the time frame.
What is scalping?
First, we need to establish a definition of scalping:
Scalping is a trading style that profits from small price changes in any financial instrument, be it for example stocks, oil or forex. The time horizon is very short: from just a few seconds up to a maximum of some minutes. The main idea is that small profits per trade generate big profits done many times. As such, this is a strategy that could be labeled as high-frequency trading.
Obviously, scalping is day trading. However, a trading day is at least 6.5 hours, so even for day traders scalping involves a very short time frame.
What is your edge when scalping?
As always, when you want to start trading you need to ask yourself these very important questions:
- How and why should you make money scalping?
- What is your edge compared to the other players?
- What is your prey, and where are you in the food chain? You need to understand the ecology of the markets.
- Do you have the mental skill set to perform scalping?
In a previous article, we both defined a trading edge and how you can go about to fin them. In the long-run, it pays off to do due diligence on the questions listed above.
Who are your competitors?
In order to make a profit, you need prey. Who is that going to be? As a scalper, you compete with many sophisticated players like banks, hedge funds, and traders sitting much closer to the market than you do. Are you going to outcompete these on their home turf? That is pretty unlikely and very naive. Better charting or indicators are not going to help at all.
High-frequency traders (HFT) are much better equipped than you are. They have better software, better brainpower (most likely) and are better capitalized. Last but not least, they are much closer to the relevant exchange and have shorter latency. Speed is of the essence when scalping, and sitting in some remote apartment on the other side of the world is not exactly an advantage.
Strategies to scalp
Scalping is in practice no different than any other strategy. The only difference is the time frame. You can scalp based on support and resistance, Bollinger bands, volume breakout, news, and for example indicators. It’s like any other algorithmic trading strategy.
The main problem is that the opportunities for profitable scalping are a lot fewer than most traders imagine.
If you still want to scalp for small profits, make sure you scalp something that is backtested or quantified. Most, if not all, articles based on scalping are just anecdotal evidence. Anyone can put up a chart and show some successful trades. But you need to define your strategy very accurate so you are able to test it on historical data. But that is easier said than done:
Backtests unlikely to reflect scalping profitability
The first drawback of scalping is that any backtest or quantified edge are unlikely to give any realistic probabilities of success. Our experience indicates there is a correlation between quantitative testing and later trading success, but this is unlikely when employing very short-term time frames. Any backtests relying on short-term data are unlikely to reflect the realities when you start scalping real money. There is too much noise and randomness. Furthermore, transaction costs most likely eat up most of the theoretical profits.
We have a rule of thumb: Backtests based on longer time frames are much more robust.
Commissions and slippage
These small spreads, plus a comparable amount for commissions, don’t look like large hurdles to overcome in isolation: they come toless than 0.1 of the percentage level for stocks. What an illusion. The bid/ask spread plus commission plus bad execution quickly adds up to a staggering load.
-Victor Niederhoffer, The Education of A Speculator, page 177
Every transaction involves costs, either obvious ones like commissions, or “hidden” costs like slippage.
Let’s start with commissions. Many traders are happy you can trade stocks without commissions. During 2019 Interactive Brokers and other brokers offered free trading in stocks (for US residents). However, we argue there has never been easier to lose money trading.
Why? Because free commissions and access to lots of info inevitably lead to overtrading. Nassim Nicholas Taleb once wrote that if you want to bankrupt a fool, give him lots of info. Info and free commissions are ingredients for overtrading and overconfidence.
What is slippage?
Slippage is the “hidden” cost of getting an order filled. Slippage is what puts most scalpers out of business. If you are a scalper and want to initiate a trade on a breakout of 100, you face the challenge of getting a fill when the market shows a bid of 100.02 and an offer of 100.05. You are unlikely to get filled at 100.01.
What do you do? Do you put in a limit order and risk not getting a fill, or do you “hit” the seller at 100.05 for a much worse execution price? This is slippage! When you close your position, slippage will be an issue all over again.
Over time slippage amounts to staggering amounts, and is a big hurdle to overcome if you want to make a profit via scalping. It’s of course an obstacle for any trader or time frame, but the smaller the profit potential, the bigger the obstacle.
Slippage is very difficult to estimate in backtesting, but traders usually underestimate the difficulty of executing the strategy according to the backtest. We think it’s safe to assume you need a wide margin of safety for this when backtesting scalping strategies.
Scalping involves stress
The shorter the time horizon, the more stress. We believe this is a great rule of thumb.
Stress comes in two forms. One is stress from sitting in front of the computer and watching price changes, and the second in the form of executing trades. Even if you automate the execution part, which is more or less a necessity, you get mentally tired of watching the market.
Scalping requires automation
It’s impossible to scalp without automation. No one is gone to provide that software to you, and no one will give you any strategies for free. You need to do this all by yourself or together with someone else.
We at Quantified Strategies use Tradestation and Amibroker, two very great tools for trading, but not for very short-term scalping. Your competitors have both better tools and access to the markets.
When you automate a lot can go wrong. You are exposed to “fat finger” mistakes and potentially big losses. You need to make sure you have a cushion to accommodate for mistakes.
A real-life example of the difficulties of scalping
We know a guy that invested considerable amounts of money to set up an infrastructure to profit from short-term scalping on Eurex futures. He spent months to backtest, fine-tune his data sets, and install and develop software. The icing on the cake came when he managed to get a co-location within the exchange. What could go wrong?
Unfortunately, another scalper was faster than him. Our friend just managed to break-even. He tried to tweak his set-up to be number one. All in vain. After a few months, he was number three and lost his shirt. He quit trading altogether.
Do this instead:
The marginal profit potential per trade makes it very hard to backtest scalping strategies. Our experience indicates it’s easier to find edges and strategies on longer time frames. The longer the time frame, the bigger the profit potential per trade. Thus, you are less likely to be disappointed when you test out of sample or with real money.
We have provided dozens of examples of quantified trading strategies on one of our landing pages:
What are the common features of those strategies? They are mostly based on stocks and indices. We believe it’s easier to make money on stocks than for example forex.
When stock prices fall, the risk premium increases. When the premium increases, you are most likely rewarded for taking that risk. You additionally have a nice tailwind from corporate profits and inflation. Then why start scalping in forex (which is extremely competitive)?
Many of the strategies we have provided for free have worked for two decades and more. Of course, it’s no guarantee they will continue to perform well. When too many traders start looking for the same ideas, the window of opportunity gets smaller.
Perhaps it’s not even a good idea to trade at all, no matter the time frame. Perhaps long-term investing suits you better? You will not get filthy rich by long-term investing, but you highly likely end up with a nice gain as long as you are patient and diversified. This doesn’t require much time nor knowledge from your side, all you need to do is to invest in some mutual funds. It’s not very exciting, we admit that, but the odds of reasonable success are much better than any trading strategy.
Conclusion: Scalp, trade or invest?
We at Quantified Strategies have never been scalpers. We have done extensive day trading in our careers, but we have avoided scalping at all costs. The reason is simple: we have not found a consistent way of making money. That doesn’t mean it’s impossible to make money on scalping, but we believe it’s very difficult. There are greener pastures that offer better risk/reward than scalping. We prefer to use a longer time horizon.
Scalping or trading are typical activities that very few succeed in but has the potential of being scalable if done successfully. This is what attracts a lot of people to the trading arena. However, anything that is scalable usually means that a very few winners take most of the profits.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.