Scalping Trade Strategies

April 14, 2009

www.fxcm.com
sales@fxcm.com

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 markets 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 newor pick up oldtechnical 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 crowds behavior or their mere presence is a self-fulfilling prophecy), but one thing is for surethese 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 levels 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 markets 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 1minute 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.

6000
2000
-2000 0
-6000

Quarterly Profits and Losses in the RSI Scalping Strategy

RSI Scalping Strategy Performance Against Shifts in M arket Volatility

-4

-2

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 overlapbetween 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?

3.2
2.8
2.4

Spread in Pips

3.6

Spread in the Euro/US Dollar By T ime of Day

10 11 12 13 14 15 16 17 18 19 20 21 22 23

Hour of Day in New York Time

25 30 35 40 45 50 55

Range in Pips

Hourly Range in the Euro/US Dollar By T ime of Day

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 timeoften 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 strategiesa mix of good spreads and low volatility.
Whats 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.