Scalping (trading)
Encyclopedia
Scalping, when used in reference to trading in securities, commodities and foreign exchange
, may refer to
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
which does not involve a relationship of trust and confidence between the fraudster and his victims.
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.
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
, may refer to
- a fraudulent form of market manipulationMarket manipulationMarket manipulation describes a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a security, commodity or currency...
- a legitimate method of arbitrageArbitrageIn economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
of small price gaps created by the bid-ask spread. - a legitimate method of trading based on quick momentum trades triggered by order flow reading setups.
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 StatesSupreme Court of the United States
The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...
has ruled that scalping by an investment adviser operates as a fraud
Fraud
In criminal law, a fraud is an intentional deception made for personal gain or to damage another individual; the related adjective is fraudulent. The specific legal definition varies by legal jurisdiction. Fraud is a crime, and also a civil law violation...
or deceit upon any client or prospective client and is a violation of the Investment Advisers Act of 1940
Investment Advisers Act of 1940
The Investment Advisers Act of 1940, codified at through , is a United States federal law that was created to regulate the actions of investment advisers as defined by the law.-Overview:The law provides in part:-Contents:...
. 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
Securities Exchange Act of 1934
The Securities Exchange Act of 1934 , , codified at et seq., is a law governing the secondary trading of securities in the United States of America. It was a sweeping piece of legislation...
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
Pump and dump
"Pump and dump" is a form of microcap stock fraud that involves artificially inflating the price of an owned stock through false and misleading positive statements, in order to sell the cheaply purchased stock at a higher price....
which does not involve a relationship of trust and confidence between the fraudster and his victims.
How scalping works
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, in order 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.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.
Principles
- Spreads are bonuses as well as costs - Most worldwide markets operate on a bid and askBid and askPrice mechanism is an economic term that refers to the buyers and sellers who negotiate prices of goods or services depending on demand and supply. A price mechanism or market-based mechanism refers to a wide variety of ways to match up buyers and sellers through price rationing.An example of a...
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. 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 tradingDay tradingDay trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...
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, i.e. 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 large-capital traders seeking to move large volumes at once, but for small-capital traders seeking to move smaller volumes more often.
Different parties and spreads
Whenever the spread is made one (or more) party must pay it (paying the cost to receive some value on completing the transaction quickly) and some party (or parties) will receive that money as profit.Who pays the spreads (costs)
The following traders pay the spreads:- Momentum traders on technicals - These traders 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 breaks out, the price becomes very volatile as many people watching the news will react at more or less the same time. A trader needs to take the market prices immediately as the opportunity 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 foreign exchangeForeign exchangeForeign exchange may refer to:Finance* Foreign exchange markets, where money in one currency is exchanged for another* Exchange rate, the price for which one currency is exchanged for another...
(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 rateExchange rateIn finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
between EuroEuroThe euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...
and United States dollarUnited States dollarThe United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
is 1.2733 at 15:45. The internal (inter-bank dealers) bid/ask price is 1.2732-5/1.2733-5. However the foreign exchange 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 - The 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. Some scalpers like to trade in a more liquid market since they can move in and out of large positions easily without adverse market impactMarket impactIn financial markets, market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e. upward when buying and downward when selling...
. Other scalpers like to trade in less liquid markets, which typically have significantly larger bid-ask spreads. Whereas a scalper in a highly liquid market (for example, a market maintaining a one-penny spread) may take 10,000 shares to make a 3 cent gain ($300), a scalper in an illiquid market (for example, a market with a 25 cent spread) may take 500 shares for a 60 cent gain ($300). While there is theoretically more profit potential in a liquid market, it is also a "poker game" with many more professional players which can make it more difficult to anticipate future price action. - 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.
- 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 trend traderTrend followingTrend following is an investment strategy that tries to take advantage of long-term moves that seem to play out in various markets. The strategy aims to work on the market trend mechanism and take benefit from both sides of the market, enjoying the profits from the ups and downs of the stock or...
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 managementRisk managementRisk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
never allowing a loss to accumulate.