Forex Scalping - Criticism and Disadvantages
Updated: May 16, 2013 at 7:59 AM
This article is part of our guide on how to use scalping techniques to trade forex. If you haven't already we recommend you read the first part of the series on forex scalping.
Scalping is popular, and profitable for some traders, but it is not without its risks. While trading, many scalpers are similar to marathon runners. They need to capitalize quickly on arising opportunities, and if those opportunities fade, a profitable trade must be a losing one, because a typical scalper will not wait long enough for another opportunity to arise for the same trade. The advantage of this approach lies in the many profit opportunities presented. For a long term trader, even a swing trader, one loss in a trade is by definition a big and important loss. Long term trades require considerable investment in time, and energy before they are profitable, and failure in one is an important setback. The scalper doesn’t suffer from this problem. He can fail in any single trade, regardless of its time or place, and still make a profit if the overall balance of his positions is profitable. This aspect can sometimes reduce stress, and create a more optimistic trading psychology as well.
Yet, short-term trading does not, by any definition, offer the keys to a smooth and risk-free path to great profits. The scalper is playing a game of probability, while the long-term trader is playing the same game with the help of fundamental analysis and strategies. Although each trade is a lot less important for the scalper, in order to profit, he must still succeed in the overwhelming number of his decisions. A scalper will enter and exit his positions while trading a trend, but he still has to make choices about the direction of the main price action. While trading a ranging market, the scalper may not need to make many decisions about directionality, but he has to have a good idea on how long the low volatility environment will last. In other words, discipline and planning are just as important for scalpers, but in a different way in comparison to what is usually experienced by other traders.
In this section we’ll analyze the scalping strategy and discuss some of its disadvantages so that you can trade with calmer, more reasonable expectations while employing it. Our purpose is not contradicting the experiences of successful scalpers, or discouraging those who desire to adopt this method for future profits, but merely to help you recall that the strategy does not offer risk-free, easy trades for beginners or undisciplined individuals.
The “Brokers Hate Scalpers” myth
First of all, let’s consider this venerable myth that has been publicized over the internet on both forums and blogs dedicated to forex trading. The argument of the propagators of this myth goes as follows: “Scalpers take little risk while trading, and are often successful. In order to hedge their positions, forex brokers counter-trade their clients, with the consequence that if a trader makes a profit, the broker, by counter-trading his position, suffers losses. Of course that makes brokers hate scalpers.”
Let’s first state that no forex trader will do himself any good by making real, or imagined enemies of brokers. Regulated brokers are monitored by authorities, and most of the firms in the business are legitimate actors with decent practices. There’s no way of trading the market without brokers (or ECN’s, but they are not used very often, and have their own disadvantages). And there’s no logic or merit in demonizing brokers as crooks or thieves. We, as traders, want to trade the markets, and to do that we need the services of firms which are monitored and regulated by the authorities.
In previous sections we have already discussed how brokers hedge against client losses, and noted that a majority of client positions can be netted out against each other without the broker having to commit any funds. In fact, when such matches can be found, the broker does not even need to pass the buy or sell order client to the bank: all that it must do is matching the order with another customer’s opposing order while pocketing the commission, and assuming zero risk. The problem with scalpers arises because their rapid entry/exit orders make the task of hedging hard for forex brokers with slow servers or outdated software. When they can’t do so, they get nervous, become worried that the scalper is trying to manipulate the system (exploiting latency issues, as they are called), and sooner or later terminate the forex account of the scalping trader.
There are no statistics on the success ratio of scalpers, but there is no reason to assume to their success rate is any different from that of the overall market. Indeed, scalping is a demanding, and somewhat more sophisticated trading style in comparison to day-trading, or swing trading; there is no reason to expect that beginners will do better in scalping in comparison to their performance in these other trading styles.
Our analysis is confirmed by the public statements of many forex brokers present on websites and blogs throughout the web. The majority of established brokers actually have the stated policy of allowing scalpers to open or close positions in as short a time period as they desire. What is more, since scalpers trade much more frequently than regular traders, they are a good source of revenue for any kind of forex broker. No broker with an updated software and platform would be willing to deny scalpers the style which they like most unless he wants shrink his own business.
Is it a good idea to scalp in strongly trending markets?
Many traders favor scalping in strongly trending markets. This approach is defended on the basis of the notion that scalpers thrive in volatility, and that trends cause a great deal of volatility creating many trading opportunities. But is this idea justified on the basis of facts and analysis?
Let’s first remember that while scalping, one misplaced, carelessly created trade can wipe out the gains of tens of successful trades in a short time. A scalper needs consistency above everything else. Discipline in trade sizes, take profit, and stop-loss orders, and a degree of skepticism towards arising opportunities are important components of a successful trading strategy. Let’s ask ourselves, then, which kind of markets offer the best conditions for the implementations of these principles? Would scalpers thrive in strongly trending and volatile markets, or quiet, calm markets where activity is subdued and volatility is low? Naturally, the best conditions will be found in the latter. Calmer markets allow us to exploit small fluctuations over a long time with little risk and good profits. Trending markets move rapidly, with widening and contracting spreads, where exiting a position before it reaches its full potential can be dangerous, and maintaining a calm and composed attitude is an additional problem.
We read online that scalping is best in strongly trending, liquid, volatile markets, and some of us wonder why so many people subscribe to these beliefs. This attitude is present either because the traders who write the articles don’t have that many experiences in scalping or because they use scalping strategies on a trend following scheme. The latter approach is not very useful to beginners, however, because they mostly choose the scalping style to make quick profits without worrying much about analysis or strategy.
Picking up coins from a railroad
Indeed, scalping after news releases, or during very strong, volatile micro-trends can be similar to picking up coins from a railroad for a living. A determined practitioner can create a sizable income from this practice if he is persistent and patient enough, but also takes a small risk that can be extremely costly if it is not properly protected against. What is the risk? Of course, it is that he will be run over by the approaching train of a market shock, and will lose all his profits, and his ability to make any profit in the future as well. Is this a valid negotiation, a compromise? The answer to the question depends on your personality and approach to life in general.
During a trend, the scalper cannot exploit “idle volatility”, or the directionless fluctuations that are often found in ranging markets. Since the market is strongly directional, he has to find a way of identifying the trend and exploiting it with small sized, and numerous orders.
Scalping is probably not the best choice for a beginning trader. The style demands constant attention, concentration, and diligent adherence to principles. The fact that trades are small-sized and quick means that there is a need to be very methodical about trade sizes especially, because irregular sizes will make us blind while trying to determine the performance of our account, and prevent the achievement of a smooth, regularly rising trading account.
For a real scalper, fear is not the main emotional issue, unlike the case with many other types of traders. Since risk in each trade is usually very small, and it is possible to stop and exit any position without much trouble, there is little danger of the account being wiped-out or greatly reduced as a result of any single trade. Yet, the major emotional issue faced by scalpers is overtrading and agitation.
Scalping requires patience. The trader must open many positions in the course of a single hour on an ordinary day, and at times, the slow accumulation of profits can be very frustrating. The trader may regret that he’s spending so much time trying to profit from minute price fluctuations. He may feel dismayed that so much effort bears so little fruit. Many other factors can lead to dissatisfaction and unhappiness which can cause the trader to enter an agitated state of mind. And yet, agitation is the worst enemy of a scalper. His finger must press the right buttons on the screen, must enter the correct prices, and place the proper decisions many times during the trading hours, and an uneasy, nervous mind will be prone to making many errors. A nervous mind will make the scalper feel like he’s fighting the markets, and lead to many unjustified and deleterious trading decisions.
The scalper must know where to stop, and yet if he’s nervous, he’ll be unable to stop. Overtrading, based on the belief that the next trade will be the successful one “since one’s luck can’t go wrong so often” may quickly erode the account balance of any trader, and it’s especially dangerous for the scalping strategy. It is on the whole a good idea to suspend scalping activity if you’re feeling that the emotional burden of scalping is too much for you at any time. Do not fight yourself, or the market, but stop trading for a while. It is certainly better than losing your wits trying to profit by battling the market, in other words, trying to improve by worsening your condition.
Getting rich, or enriching the broker?
The scalper is running against time in his dealings with the broker. He will make profits, suffer losses, open and close positions with different scenarios in mind, but in all that while he will still be paying the broker his due in the spread. Regardless of the size of profits or losses, the broker’s share must be paid, and the trader has to earn at least that much to make sure that his account is not bleeding money.
The broker’s fee in the spreads is almost negligible when trading on a long term basis. A 3-pip spread cost is insignificant for a trader who makes 50-60 pip profit in trading, or even more in positions held over even a longer time. But the scalper’s profits are usually much smaller, in many cases closer to 5-10 pips for a competent person, and the spread is anywhere between 30 to 50 percent of the gains.
Any scalper should keep a list of his trades which shows his actual gains, losses, and the amount that is paid to the broker. If the cost of the spread is about twice as big as the profits of trading, it is a good idea to change the trading strategy used, or to change the broker and open an account with another one which requires lower spreads. If average profit in pips is equal to the spread, our trade record can be improved, and better profits are possible. In the unusual case that the scalper’s profits are a lot larger than the spread it is time to add funds to the account, or perhaps increase leverage gradually.
Traders need not be worried when the broker is making good profits. As long as the relationship is reciprocal, there is no harm in seeing the broker making gains which are even more sizable than what is achieved by the trader. The threshold is profitability. As long as we are gaining from activity, there’s no reason to be worried about the fact that the broker is also benefiting from the relationship.
Let’s conclude this part by briefly discussing the dangers posed by faulty interpretation of data. Sadly, many beginning scalpers still evaluate their results on the basis of some ethereal concept termed luck. In a string of wins, good luck is thought to be the causal agent, while a strong of losses makes us think that we have no luck on that day. Since many believe that one cannot have bad luck continuously, there’s a tendency to expect profits soon after a string of losses, and vice versa. Since individual results in short term trading are random, there is no justification for this reasoning, and at least as far as mathematics is concerned, a gain or a loss are equally likely even after a string of ten or twenty gains or profits in a raw.
The other issue which traders must grapple with while evaluating their results is the clustering illusion. In this case, traders will see “order” in a string of random data (such as a list of scalping trade results). After seeing a string of, let’s say, five wins, they will begin to assume that this time their strategy makes wins more likely, and in response they will increase trade sizes, with often disastrous results.
In order to achieve profitability and a degree of safety in scalping it is extremely important that consistency in trade sizes be maintained. If you make small profits with ten 1 lot scalps, and occasionally decide to throw in 3, 2 lot trades where you feel you’re doing well, you’re taking the risk of never going beyond breakeven, in the best case scenario. Make sure that you don’t get deluded by luck, or the clustering illusion to randomize your trade sizes. You can instead use methods like the z-score to see if the win-loss streaks of your scalping strategies are any different from random results.
Next >> Forex Scalping Guide - Conclusions >>
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