A beginners' guide to a forex scalping strategy
Find out what scalping in forex is and learn about 5 of the best indicators for this trading style.
What is scalping in forex trading?
Scalping in forex trading is a style that involves opening and closing multiple positions on one or more forex pairs over the course of a day, usually in seconds or minutes. Instead of opening one position at the start of a trend and closing it at the end, scalpers will open and close several positions over a trend’s course.
Forex scalpers aim to gain just a few pips at a time, looking for multiple small gains rather than fewer larger ones. A pip is a common unit of measurement of movement in forex trading, denoting a change in price at the fourth decimal place. For example, if the quoted price of a forex pair decreases from 1.3980 to 1.3979, it has fallen by one pip. There are some exceptions, such as the Japanese yen, that are quoted to two decimal places.
Scalpers often use derivatives like CFDs to trade forex pairs that are rising or falling in value. They’ll open a position to ‘buy’ (go long) if they think the price will rise and open a position to ‘sell’ (go short) if they think the price will fall.
Leveraged products like these also enable traders to open a position with a deposit, called a margin. This can amplify profits but can just as easily magnify losses, because your profit or loss are calculated from the full value of the position. That’s why it’s vital to have an appropriate risk management strategy in place no matter which scalping techniques you’re using.
Things to consider before you start scalping forex
Before adopting a forex scalping strategy, it’s important to understand currency liquidity and volatility, and the pros and cons of this trading style.
Liquidity in forex scalping
Around $6.6 trillion worth of forex transactions take place every day, which makes it the most liquid market in the world. Liquidity refers to the ability to buy and sell quickly without affecting a market’s price. High liquidity makes forex a good market for scalpers, who need to enter and exit their positions quickly – sometimes within seconds.
The liquidity of a currency isn’t fixed; it’ll change based on a number of factors, including the time of day, the number of traders that are active in the market at any given moment and wider economic conditions like the countries’ inflation rates (GDP). The most liquid forex pairs tend to be those most traded, such as EUR/USD, GBP/USD and USD/JPY.
In highly liquid markets like forex, the bid-offer spread tightens, making the transaction costs affordable despite the large volume of positions scalpers open. Because gains are incremental, smaller spreads allow for greater profits.
In other markets, liquidity often means stability, but forex is highly volatile. This means major short-term price movements can happen at any time, which can cause the value of currencies to spike up and down in seconds. This volatility presents opportunities for greater profits – another reason why scalpers often favour forex. But conversely, this can also lead to an increased exposure to risk.
Volatility in forex scalping
Volatility is favourable when trading derivatives, as it allows traders to profit from rising and falling market prices. But it’s important to have a risk management strategy to minimise losses, especially when using leverage to open a position. Because scalping is most successful when markets are volatile, the best time to open a position is during the session’s open and close.
When you’re learning how to scalp forex, it’s important to bear in mind the following pros and cons of this trading style:
|Forex scalping pros||Forex scalping cons|
|Magnify gains with leverage||Magnify losses with leverage|
|Open and close positions quickly||Potentially wipe out small wins with one large loss|
|Trade on hundreds of forex pairs||Risk your money on a highly volatile market|
|Reduce losses by holding positions for a short time||Gain profits slowly due to small incremental wins|
Many traders use Bollinger Bands to indicate areas of market volatility. Bollinger Bands rely on a simple moving average (SMA) with a standard deviation set above and below to show how volatile a market might be.
Traders assume that wider standard deviations indicate increased volatility in the underlying market. In contrast, if the bands are narrow it might mean that the underlying market is stable.
When the standard deviations (bands) widen, traders refer to it as a ‘Bollinger bounce’ – which is taken to be indicative of an upcoming retracement. Narrowing bands are known as a ‘Bollinger squeeze’, and this is taken to indicate an upcoming breakout in the underlying asset.
When used in conjunction with other forex scalping indicators, Bollinger Bands can form part of an effective scalping strategy.
Moving average (MA)
A moving average is a mathematical formula used to help spot emerging and common trends in markets, represented as a single line showing an average. There are two types of moving average – simple moving average (SMA) and exponential moving average (EMA). Moving averages are popular indicators in most forex scalping strategies, as they’re easy to read.
An SMA adds a set of numbers and divides by the number of values in that set. For example, a scalper may add up the price of a currency pair at intervals of five minutes over one hour, and then divide the total number by 12.
Forex scalpers will typically look at shorter-term averages and one longer average to indicate a trend.
You can read the three lines in the above USD/ZAR pair as follows:
- Red indicates a general trend over a 200 period
- Black indicates a 20-period trend
- Green indicates a five-period trend
Forex scalpers will look for the point where the five-period moving average crosses above the 20 period, opening a position in the direction of the trend. This is indicated at the arrows.
An exponential moving average (EMA), on the other hand, seeks to react to more recent price changes. In the same currency pair, we can see in the example below how each moving average – at periods of three, 12 and 100 – pull tighter together as the data indicates more up-to-date activity.
A stochastic oscillator is a technical indicator that compares the current value of a forex pair to its range over a recent period of time. Scalpers can use the stochastic oscillator to predict when a trend may turn bullish or bearish.
On a stochastic oscillator, when the solid black line – called the %K line – crosses the dotted red line – called the %D line – it’s a sign that a change in market direction is imminent. These rises and falls tend to happen at the extremes of a recent price range.
If %K rises above %D, it would be a buying signal, and if %K falls lower than %D, then it’s a selling signal. You can see this in the graphic below:
In this example, which looks at USD/CHF on a three-minute time frame, the arrows point to a buying signal, so a scalper would consider opening a long position at this point. They’d then close their position when the %K line crosses below the %D line at the top end of the range.
Conversely, a scalper might open a short position when the %K line crosses below the %D line at the top, and close their position when it crosses above the %D line at the bottom end of the range.
Parabolic stop and reverse (SAR)
The parabolic SAR is a technical indicator displayed as dots above or below the market price. Scalpers use it primarily to spot potential reversals to discover the best time to enter and exit a market.
When red dots are above the current price, it acts as a sell signal, indicating that a bearish market is imminent. When green dots are below the current price, it’s seen as a buy signal, indicating a potential bullish market. After a series of red dots, for example, scalpers might take the appearance of the first green dot following a series of reds as the start of a bullish reversal – opening a position to go long in the process. Conversely, if a red dot appears after a trend of green dots, a trader might choose to open a short position.
In the following AUD/JPY example, the arrows indicate points where a scalper would open a position, going long or short depending on the trend reversal.
Relative strength index (RSI)
The RSI is a momentum indicator that uses a range of between zero and 100 to assess whether an underlying market’s current direction might be about to reverse. It uses levels of support and resistance – set at 30 and 70 respectively – to identify when the market’s trend might be about to change direction.
When the RSI rises above 70, it might show that the market is overbought and a trader may benefit from opening a short position. If the RSI falls below 30, it might indicate that the market is oversold and a trader should open a long position. In our example of the GBP/JPY pair, you can see how the RSI moved above 70, indicating an imminent trend reversal.
Scalpers should be aware that using the RSI on a short time frame can lead to more premature or false signals.
Scalping in forex summed up
- Forex scalpers open and close positions multiple times during the course of a trend, usually over seconds and minutes
- You should consider the market’s liquidity and volatility before adopting a forex scalping strategy
- Derivatives like CFDs enable traders to go long or short on the price of forex pairs
- Opening a position with a margin allows traders to magnify their profits, but it can also amplify their losses
- You can use technical indicators including Bollinger Bands, moving averages, the stochastic oscillator, parabolic SAR and RSI in your forex scalping strategy
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