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 our series on forex scalping.
As important as basic concepts like leverage and spreads are for forex scalpers, they are still secondary subjects in comparison to issues related to the broker, his attitude and preferences. Quite simply, the broker is the most important variable determining the possibility, and profitability of a scalping strategy for any trader. A scalper has control over his strategies, stop loss, or take profit orders, as well as his time frame for trading, but he has no say in matters such as server stability, spreads, and the attitude of the broker to scalping.
There are hundreds of brokers operating in the retail forex market today; naturally, each has a technical capability, and business model suitable to a different trader profile. These differences are immaterial to most long term traders, for swing traders they are meaningful but not that significant, but for day traders and scalpers they are the distinction between profit and loss. At the very basic level, the spread is a tax paid on profits and losses to the broker for his services, but the relationship goes a lot deeper than that. Let’s take a look at the various issues related to the scalper-broker relationship. (Once you’ve read this article make sure to stop by our forex broker review section to find more informations on the most popular retail forex brokers and compare features.)
A trader who doesn’t use the scalping or day-trading strategies will open and close may be one or two positions, at most, in a single day. Although the cost of the spread is still an important variable, a successful trading style can easily justify the relatively small fees paid to the broker. The situation is quite different for the scalper however. Since the scalper will open and close tens of positions in a short period of time, the cost of his trades will be a very significant item on his balance sheet. Let’s see an example.
Suppose that a scalper opens and liquidates 30 positions on a day in the EURUSD pair, for which the spread is commonly 3 pips. Let’s also suppose that his trade sizes are constant, and that 2/3 of his positions are profitable, with an average of 5 pips profit per trade. Let’s also say that the average size of his loss is 3 pips per trade. What is his net gain/loss without the cost of the spread included?
(Positions in black) – (Positions in red) = Net profit/loss
(20*5)-(10*3) = 70 pips in total.
Which is a significant gain. Now let’s include the cost of the spread, and repeat the calculation.
(Positions in black) – (Positions in red + Cost of the Spread) = Net profit/loss
(20*5)-(10*3+30*3) = -20 pips in total.
A nasty surprise awaits our hypothetical trader in his account. The number of his profitable trades were twice the number of his losing ones, and his average loss was about half his average gain. And in spite of that remarkable track record, his scalping activity gained him a net loss. To break even, he would need an average net profit of 9 pips per trade, all else remaining the same.
Now let’s repeat the same calculation, with another hypothetical broker where the spread is just 1 pip in the EURUSD pair. The 5 pips per win, and 3 pips per loss (the same scenario which was examined in the beginning) with a one-pip spread would bring us an outcome of
(20*5)-(10*3+30*1) = 40 pips in total profit.
Why is there such a large discrepancy in our results? Although the numbers do speak for themselves, let’s remind the reader that while we earn money only on our profitable trades, we pay the broker for every position we open, profitable or not. And that is the problem.
In sum, we need to ensure that we choose the broker with the lowest spread for the currency pair we’d like to trade. A scalper must scrutinize the account packages of different brokers thoroughly before deciding to become a client of one of them.
What is a scalping policy? Although the majority of well-established firms with a history and a significant client base have an official policy of allowing scalpers freedom with their decisions, some brokers quite simply refuse to allow scalping techniques for clients. Others process client orders slowly, and make scalping an unprofitable endeavor. What is the reason?
In order to understand the cause of this, we should discuss how brokers net out their client’s positions before passing them to the banks. Supposing that a majority of a broker’s clients are losing money while trading, what would happen if at a time these losses were to reach such a large size that some triggered margin calls which could not be met? Since forex brokers are liable to liquidity provider banks for the profits or losses of their clients, they would have faced periodic crises of liquidity and even bankruptcy. In order to prevent such a situation from arising, brokers net-out the positions of clients by trading against them. That is, as a client opens a long position, the broker takes a short position, and vice versa. Since the result of two orders in the opposite direction is that the total exposure to the market is zero, the liquidity issue is resolved, and the firm is unimpacted by losses or profits in traders’ account.
But there’s a problem with this situation. We mentioned that the broker countertrades its clients’ positions, and what if the client makes a profit by closing a long position, for instance. The broker then has to close the short trade which had been opened to net out the trader’s long trade, and while doing so he incurs a loss. And well, isn’t this a great incentive for forex brokers to ensure that their clients are constantly losing money?
Well, not so much. First of all, most of the netting is done internally, where individual traders’ positions are netted out against each other without the broker having to commit any of its own funds. And the small remaining net position (the net long short or position that remains after the broker has netted out client orders against each other), is usually a losing position which can be counter-traded by the broker safely, because it is a well-established fact that the overwhelming majority of forex traders lose money.
Now that we understand that scalping does not necessarily constitute a problem for a competent broker (just like the occasional winners are not problem for casinos), we are ready to understand why some brokers dislike scalpers so much. As we said, the broker needs to net out trader positions against each other to guarantee that its liability against banks is minimal. Scalpers disrupt that plan by entering trades all over the place, at awkward times, with difficult sizes which not only forces the broker to commit its own capital at times, but also ensures that the system is bombarded with crowded trades. Add to that the possibility that the broker’s servers are not exactly lightning-fast, or modern enough to cope with the rapid flow of orders, and there you have profitable scalpers as the worst nightmare of a broker with a slow outdated system. Since scalpers enter many small, rapid positions over a short period of time, an incompetent broker is unable to cover its exposure efficiently, and sooner or later kicks the trader out by terminating his account, or slows down his access to the system so much that the scalper has to leave by his own account, due to his inability to trade.
All this should make it clear that scalpers must trade with innovative, competent, and technologically alert brokers only, who possess the expertise and the technical capability to handle the large volume of orders arising from scalping activity. A no-dealing desk broker is almost a must for a scalper. Since trades are mostly automated in the system of a no-dealing desk(NDD) broker, there is little risk of external tampering as the system is left to sort out client orders on its own (still profitable of course).
Strong technical tools
Scalping involves technical trading. In the very short time frames preferred by scalpers, fundamentals have no impact on trading. And when they do have, market reaction to them is erratic and entirely unpredictable. As such, a sophisticated technical package which supplies an adequate number of technical tools is a clear necessity for any scalper.
In addition, since the trader will spend a considerable amount of time gazing at the screen, reading quotes, opening and closing positions, it is a good idea to choose an interface that is not too wearying on the eyes. A bright, graphically intense platform may be pleasant to use and look at at first, but after long hours of intense concentration, the visual appeal will be more of a burden than a benefit.
Also, a platform that allows the simultaneous display of multiple time frames can be very useful for a scalper as he monitors price movements on the same screen. Although scalping involves short term trading, awareness of the price action on longer timeframes can be beneficial for money management, and strategical planning.
No slippage, no misquotes, timely execution
We have mentioned in the section on brokers’ scalping policies that a scalper must always seek a competent, modern broker in order to ensure that his trading style and practices are welcome. But timely execution, and precise quotes are also important for ensuring that a trader can profit with a scalping strategy. Since the scalper trades many times in the short time frame of an hour, he must receive timely, correct quotes on a system which allows rapid reaction.
If there’s slippage, the scalper will be unable to trade most of the time. If there are misquotes, he will suffer losses so often that trading will be impractical. And we should not neglect the emotional pressures which will be caused by such a stressful, difficult, and inefficient trading environment either. Scalping is already a burdensome activity on one’s nerves, and we should not agree to suffer the added trouble of broker incompetence on top of all the other problems which we have.
To conclude this section, we’ll add that scalping is a high-intensity technical trading method which requires a highly competent and efficient broker with state-of-the-art tools. Anything less will diminish your profits, and increase your problems.
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