www.fxcm.com sales@fxcm.com Scalping Trade Strategies April 14, 2009 DailyFX Research Team John Kicklighter David Rodriguez Currency Strategists 1-212-897-7660 1-888-50-FOREX (36739) Just a decade ago, scalping was a lucrative form of trading that only pit traders could partake in. With tight spreads and a clear view of the market, the hustle and bustle of the open outcry market was perfectly suited for many quick entries and exits for five or ten basis points at a time. Now, however, with access to the deep liquidity of the currency market along with improvements to technology and data flow, retail traders have now found their way into the trading space formerly dominated by professionals. However, entry alone does not guarantee success. In fact, for the unprepared it merely presents a means to lose their money more quickly. Without the entire market trading in front of you, successful scalping requires a definitive strategy that takes advantage of inefficiency or even a natural characteristic of the market that is only seen through very short time frames. In this article, we will highlight three scalping strategies for the currency markets: scalping around event risk; near key technical levels; and through ranges and mean reversion. Event Risk Trading For many of the uninitiated, first time currency traders, the lure of high volatility that develops after a major economic indicator or any otherwise scheduled piece of event risk is announced offers the opportunity for quick profit. However, inexperience and the wrong strategy often lead to a quick loss. On the other hand, the presence of these indicators nevertheless has an objective impact on price action. Volatility leading up to a major event settles as traders try to avoid taking a significant position on the fear of an unfavorable surprise. During the actual release and up to a few minutes afterwards, activity often surges as the market absorbs the data. The normal retail traders short fall in this scenario is that they are trying to trade the data itself and are looking for a significant move in a single direction (and often without any drawdown along the way). For a scalper, there is no bias on the data aside from the potential for a jump in volatility. To present this strategy, we will make an example of the U.S. Nonfarm Payrolls (NFPs) report. Preparation begins well in advance of the actual event risk. At the beginning of the week (or even the beginning of the session), we will look for significant indicators or events considered market movers that threaten stable price action. In the image below we have filtered the DailyFX Calendar (http://www.dailyfx.com/calendar) for all the events over the period of a week and chose an indicator that showed promise for generating price action. The NFPs has proven itself to be a consistent driver of volatility over the past; so we can reasonably expect activity to increase around its release (again, the actual outcome is not important).
There are three key stages to a market s reaction to a significant economic indicator. In the lead up to a release that could potentially turn a market or otherwise boost activity, there is often a slump in price action. Retail capital is held in the wings as traders await the actual release to trade, while institutions and banks look to hedge themselves to avoid the shock the market may be in for. What results from the drop in open interest is usually a tight range (sometimes imbued with a modest bullish or bearish bias). For this particular report, the chop began a few hours before the actual report was released. With a range of 10-15 points, there is little room for the traditional trader to take a position. However, these are ideal conditions for a scalper who is able to repeatedly trade in and out of the market for 4-10 points each swing with a relatively tight stop set outside of the range itself. The effectiveness of trading this phase of the strategy depends on the range and the width of the bid/ask spread.
U.S. Nonfarm Payrolls report announced Volatility and direction wane, giving rise to a tight band of congestion Spreads return to normal and the market works out a consistent direction Typically, most speculative traders are interested in the actual release itself and plan to trade the data as quickly as they learn of the outcome. This brings with it a number of problems including: lagging data; a reaction that is inconsistent to the fundamental outcome; gaps; and a temporary widening of spreads. With such shortfalls, a scalper should clearly avoid these unfavorable conditions. While the shock of an indicator or other event announcement can be significant, the influence on the market environment does not last for long. From our example, the surge in volatility and open spreads lasted no longer than a few minutes. Afterwards, the market found a directional bias; but overall, the swings were subdued as the market efficiently ran through preset orders or market participants otherwise took their positions off. This cowed period allows the market to develop new or pick up old technical formations while allowing for wider ranges. Scalping Around Key Technical Levels For most forms of trading, speculation is essential. In contrast, scalping strategies look to remove most evidence of guesswork derived by various forms of analysis. However, through a significant increase in speculative interest, the markets have shown a more consistent reaction to these now traditional forms of market benchmarking. Just like our event risk-based scalping strategy, we can see the market often has a predictable reaction to major technical levels. There are many arguments as to why a technical analysis works (it is a reflection of the crowd s behavior or their mere presence is a self-fulfilling prophecy), but one thing is for sure these trend lines and congestion zones frequently give pause to market trends and basing patterns frequently form before an ultimate reversal or breakout. For scalpers, being able to foresee a level that can curb trends and volatility presents an opportunity. As an example, we will look to EUR/USD, where a key support was setting in around 1.2765, which in turn led to a significant basing pattern. On the daily chart, the formation is evident. A rising trend line that began three months before gave pause to a steady bear trend. Initially, the first test of this line resulted in a sharp reversal; but additional trials confirmed the level s influence and price action would settle. Zooming into the one minute chart, we can seen that as price action drifted down towards the now obvious, horizontal floor around 1.2765, price action would remain choppy and largely directionless. What would be considered untradeable congestion for most traders, presents the ideal conditions for the scalper with stable and tight ranges with little hint of volatility.
On the other hand, there is always a downside to any strategy. When approaching a notable technical level, there is always the danger of a significant reversal or breakthrough. The volatility that this generates can often lead to wide spreads, gaps, and directional momentum that could generate significant losses when our aim is to be in and out of the market quickly for only a few points of profit potential. Therefore, it is essential to confirm the market s intention to yield to these technical areas rather than looking for positions on the first test. Range Trading / Mean Reversion Scalping: the art of extracting small but frequent profits on an intraday trading basis. Scalping strategies revolve around finding predictable movements in price, and they very often involve trading narrow intraday ranges. Given that currencies tend to fluctuate rapidly through the very short term, it is sometimes profitable to bet that a currency may retrace sudden moves. That being said, there are clearly times in which a range trading/mean reversion scalping strategy will not work, and it is critical to highlight the key weaknesses of this popular trading strategy.
First and foremost, the primary handicap for virtually any intraday scalping strategy comes down to one thing: transaction costs. It is always difficult to predict short-term currency moves with reasonable accuracy, but those difficulties are magnified if one is forced to pay significant sums to even trade. A prime example comes from a popular trading system: the intraday RSI strategy. The chart below shows the theoretical results of a simple RSI trading strategy assuming zero transaction costs on a one minute trading chart. Basic RSI Strategy Basic Indicator Relative Strength Index (RSI) Buy Rule Buy when 14-period RSI crosses above 30 Sell Rule Sell when 14-period RSI crosses below 70 The chart shows that this strategy has theoretically been profitable on the EUR/USD even on a 1-minute time frame. Of course, if something seems too good to be true, it usually is. For the above results we assume that the trader pays zero spread and zero comissions on every single trade. This may not seem like a terribly unrealistic assumption on many lower-frequency systems, but the 1- minute chart generated a whopping 7800 trades in a mere three-year stretch. What do our results look like if we assume a much more realistic 2 pip roundtrip cost per trade? Such high-frequency range trade strategies are extremely sensitive to transaction costs, but we likewise note that there are other very important factors to keep in mind. Our equity curves shown above show that the strategy lost substantially from March 2008 onwards. Why exactly? Extreme volatility.
Quarterly Profits and Losses in the RSI Scalping Strategy -6000-2000 0 2000 6000 RSI Scalping Strategy Performance Against Shifts in Market Volatility -4-2 0 2 4 6 8 10 Quarterly Changes in the DailyFX 1-Week Volatility Index Given such evidence, we want to avoid situations in which price is at clear risk of prolonged intraday moves. Such effects would singlehandedly destroy virtually any range trading strategy, while the increased transaction costs linked to choppy market conditions would likewise decimate a high-frequency strategy. So when and how do we trade range trading scalping strategies? Given that high transaction costs and strong market volatility will both quickly eat into any intraday scalping range trading strategy, it is important to trade when transaction costs are lowest and markets are the quietest. The charts below show important facts about the EUR/USD. First, spreads are tightest through European and U.S. trading sessions. Second, volatility tends to hit its peak at the time that New York and London trading sessions overlap between 8:00-10:00 New York time. What does this mean for us as far as range trading scalping strategies go? We want to trade during times when transaction costs (i.e., spreads and potential slippage) are the lowest, but we likewise want to avoid overly volatile trading times. When does this occur?
Spread in Pips Range in Pips 2.4 2.8 3.2 3.6 25 30 35 40 45 50 55 Spread in the Euro/US Dollar By Time of Day 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 Hour of Day in New York Time Hourly Range in the Euro/US Dollar By Time of Day 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 Hour of Day in New York Time According to our charts, we see a confluence of low spreads and low volatility at several key times in the forex trading day. After the London trading session opens, volatility slowly begins to drop while spreads hit their lowest levels of the day. This would arguably be the best time of day to employ highly transaction cost-sensitive strategies. Spreads remain relatively low through the beginning of the U.S. trading session, but we likewise note that volatility rises significantly between the hours of 8:00-10:00 New York time often linked to key North American economic reports. The next attractive window occurs between the hours of 10:05 to approximately 16:00. Volatility hits near its lowest levels of the trading day, but transaction costs do tend to creep higher. Finally, we see that the late Asia trading session provides solid conditions for scalping range trading strategies a mix of good spreads and low volatility. What s the next step? Find the appropriate strategy. Our article has thus far highlighted key strengths and weaknesses of range trading scalping strategies, but we would obviously need to find appropriate strategies to use with our information. Subsequent articles will try to find strategies that may work given different market conditions. Leveraged foreign exchange trading carries a high level of risk, and may not be suitable for all investors. Any opinions, news, research, analyses, prices, or other information contained on this document is provided as general market commentary, and does not constitute investment advice. DailyFX will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.