Definitions

bond-trading activity

Scalping (trading)

Scalping, when used in reference to trading in securities, commodities and foreign exchange, may refer to (i) a fraudulent form of market manipulation or (ii) a legitimate method of arbitrage of small price gaps created by the bid-ask spread.

Market manipulation

Scalping in this sense is the practice of purchasing a security for one's own account shortly before recommending that security for long-term investment and then immediately selling the security at a profit upon the rise in the market price following the recommendation. The Supreme Court of the United States has ruled that scalping by an investment adviser operates as a fraud or deceit upon any client or prospective client and is a violation of the Investment Advisers Act of 1940. The prohibition on scalping has been applied against persons who are not registered investment advisers, and it has been ruled that scalping is also a violation of Rule 10b-5 under the Securities Exchange Act of 1934 if the scalper has a relationship of trust and confidence with the persons to whom the recommendation is made. The Securities and Exchange Commission has stated that it is committed to stamping out scalping schemes. Scalping differs from pumping and dumping in that a pump and dump does not involve a relationship of trust and confidence between the fraudster and his victims.

Arbitrage

How scalping works

Playing the spread

Scalpers attempt to act like traditional market makers or specialists. To make the spread means to buy at the Bid price and sell at the Ask price, to gain the bid/ask difference. This procedure allows for profit even when the bid and ask don't move at all, as long as there are traders who are willing to take market prices. It normally involves establishing and liquidating a position quickly, usually within minutes or even seconds.

Role

The role of a scalper is actually the role of market makers or specialists who are to maintain the liquidity and order flow of a product of a market.

A market maker is basically a specialized scalper. The volume he trades are many times more than the average individual scalpers. He has a sophisticated trading system to monitor trading activity. However, he is bound by strict exchange rules while the individual trader is not. For instance, NASDAQ requires each market maker to post at least one bid and one ask at some price level, so as to maintain a two-sided market for each stock he represents.

Due to role overlapping, a scalper is always competing with the market maker for profits. Unfortunately, the low-end scalper is almost always at a disadvantage due to the following market maker's advantages:

  1. superior execution speed as an insider
  2. a greater knowledge of trading and the actual market situation due to its information gathering capacity
  3. huge amount of capital to backup and support market makers
  4. the ability to provide false impression to the market by placing a larger/smaller bid or ask to bluff the trader

Principles

Spreads are bonuses as well as costs

Most worldwide markets operate on a Bid and ask based system. The numerical difference between the bid and ask prices is referred to as the spread between them.

The ask prices are immediate execution (market) prices for quick buyers (ask takers); bid prices for quick sellers (bid takers). If a trade is executed at market prices, closing that trade immediately without queuing would not get you back the amount paid because of the bid/ask difference.

Spread is 2 sides of the same coin. The spread can be viewed as trading bonuses or costs according to different parties and different strategies. On one hand, traders who do NOT wish to queue their order, instead paying the market price, pay the spreads (costs). On the other hand, traders who wish to queue and wait for execution receive the spreads (bonuses). Some day trading strategies attempt to capture the spread as additional, or even the only, profits for successful trades.

Lower exposure, lower risks

Scalpers are only exposed in a relatively short period. They do not hold overnights. As the period one holds decreases, the chances of running into extreme adverse movements, causing huge losses, decreases.

Smaller moves, easier to obtain

A change in price results from imbalance of buying and selling powers. Most of the time within a day, prices stay stable, moving within a small range. This means neither buying nor selling power control the situation. There are only a few times which price moves towards one direction, ie. either buying or selling power controls the situation. It requires bigger imbalances for bigger price changes.

It is what scalpers look for - capturing smaller moves which happen most of the time, as opposed to larger ones.

Large volume, adding profits up

Since the profit obtained per share or contract is very small due to its target of spread, they need to trade large in order to add up the profits. Scalping is not suitable for small-capital traders.

Different parties and spreads

Who pays the spreads (costs)

The following traders pay the spreads:

  • Momentum traders on technicals - They look for fast movements hinted from quotes, prices and volumes, charts. When a real breakout occurs, price becomes volatile. A sudden rise or fall may occur within any second. They need to get in quick before the price moves out of the base.
  • Momentum traders on news - When news break out, the price becomes very volatile as many people watching the news will react at more or less the same time. One needs to take the market prices immediately or the golden opportunities which may vanish after a second or so.
  • Cut losses on market prices - The spread becomes a cost if the price moves against the expected direction and the trader wishes to cut losses immediately on market price.

Who receives the spreads (bonuses)

The following traders receive the spreads:

  • Individual scalpers - obviously they trade for spreads and can benefit from larger spreads.
  • Market makers and specialists - people who provide liquidity place their orders on their market books. Over the course of a single day, a market maker may fill orders for hundreds of thousands or millions of shares.
  • Spot Forex (exchanges of foreign currencies) brokers - they do not charge any commissions because they make profits from the bid/ask spread quotes. On July 10 2006, the exchange rate between Euro and United States dollar is 1.2733 at 15:45. The internal (inter-bank dealers) bid/ask price is 1.2732-5/1.2733-5. However the forex brokers or middlemen will not offer the same competitive prices to their clients. Instead they provide their own version of bid and ask quotes, say 1.2731/1.2734, of which their commissions are already "hidden" in it. More competitive brokers do not charge more than 2 pips spread on a currency where the interbank market has a 1 pip spread, and some offer better than this by quoting prices in fractional pips.

Factors affecting scalping

Liquidity

Liquidity of a market affects the performance of scalping. Each product within the market receives different spread, due to popularity differentials. The more liquid the markets and the products are, the tighter the spreads are. Scalpers like to trade in a more liquid market since they can make thousands of trades a day to add up their small profits offered on each trade.

If they are to trade in less liquid markets, they will try to cover their risks by widening their bid and ask prices.

Volatility

Unlike momentum traders, scalpers like stable or silent products. Imagine if its price does not move all day, scalpers can profit all day simply by placing their orders on the same bid and ask, making hundreds or thousands of trades. They do not need to worry about sudden price changes which kill them unprepared.

Time frame

Scalpers operate on a very short time frame, looking to profit from market waves that are sometimes too small to be seen even on the one minute chart. This maximizes the number of moves during the day that the scalper can use to make a profit.

Risk management

Rather than looking for one big trade, the way a swing trader might, the scalper looks for hundreds of small profits throughout the day. In this process the scalper might also take hundreds of small losses during the same time period. For this reason a scalper must have very strict risk management never allowing a loss to accumulate against him.

References

External links

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