Scalping: Definition in Trading, How This Strategy Is Used, and Example

What Is Scalping in Trading?

Scalping is a trading strategy geared towards profiting from minor price changes in a stock's price. Traders who implement this strategy place anywhere from 10 to a few hundred trades in a single day with the belief that small moves in stock prices are easier to catch than large ones. Traders who implement this strategy are known as scalpers. Many small profits can easily compound into large gains if a strict exit strategy is used to prevent large losses.

Understanding Scalping

Scalping utilizes larger position sizes for smaller price gains in the smallest time period of holding. It is performed intraday. The main goal is to buy or sell a number of shares at the bid or ask price and then quickly sell them a few cents higher or lower for a profit.

The holding times can vary from seconds to minutes and in some cases up to several hours. The position is closed before the end of the total market trading session.

Scalpers need to be disciplined and need to stick to their trading regimen very closely. Any decision that needs to be made should be made with certainty. But scalpers should also be very flexible because market conditions are very fluid and if a trade isn't going as expected, they'll need to fix the situation as quickly as possible without incurring too much of a loss.

Scalping Characteristics

Scalping is a fast-paced activity for nimble traders. It requires precision timing and execution. Scalpers use day trading buying power of four to one margin to maximize profits with the most shares in the shortest amount of holding time.

This requires focusing on the smaller time frame interval charts such as the one-minute and five-minute candlestick charts. Momentum indicators such as stochastic, moving average convergence divergence (MACD), and the relative strength index (RSI) are commonly used. Price chart indicators such as moving averages, Bollinger bands, and pivot points are used as reference points for price support and resistance levels.

Scalping requires account equity to be greater than the minimum $25,000 to avoid the pattern day trader (PDT) rule violation. Margin is required to execute short-sale trades.

Scalping Strategies

Scalpers buy low and sell high, buy high and sell higher, or short high and cover low, or short low and cover lower. They tend to utilize Level 2 and time of sales windows to route orders to the most liquid market makers and ECNs for quick executions.

The point-and-click style execution through the Level 2 window or pre-programmed hotkeys is the quickest method for the speediest order fills. Scalping is purely based on technical analysis and short-term price fluctuations. Due to the extensive use of leverage, scalping is considered a high-risk style of trading.

Some of the common mistakes that scalpers make are poor execution, poor strategy, not taking stop-losses, over-leveraging, late entries, late exits, and overtrading. Scalping generates heavy commissions due to the high number of transactions. A per-share commission pricing structure is beneficial to scalpers, especially for those who tend to scale smaller pieces in and out of positions.

Example of Scalping

Suppose a trader employs scalping to profit off price movements for ABC stock trading for $10. The trader will buy and sell a massive tranche of ABC shares, say 50,000, and sell them during opportune price movements of small amounts.

For example, they might choose to buy and sell in price increments of $0.05, making small profits that add up at the end of the day because they are making the purchase and sale in bulk.

The Bottom Line

Scalping is a very specific type of intraday trading that may not be suitable for all traders. It requires flexibility and discipline to profit off of small price moves on large orders. If you're thinking about scalping, make sure you're already an experienced trader or practice before putting real money to use.