Saturday, April 14, 2007

As You Name the Boat, or What Is Scalping

There is this Russian cartoon named The Adventures of Captain Vrungel. The characters set out for a deep sea trip and name their boat Victory. As the boat pushes off, they marrily sing "As you name the boat, so shall it float". Two first letters immediately (and unknowingly for them) drop off turning Victory (in its Russian equivalent) into Disaster.

Funny as cartoon is, this is what happens when we define things for ourselves. Our definitions lock us into certain way of action that are defined by our definition. I am not implying anything esoteric here, rather quite straightforward things like if you decide that walking involves leaping ahead at each third step, that's how you are going to walk. To you it may mean walking while side observers will see you as a hybrid of a human and a frog, won't they?

I start some of my seminars devoted to scalping as a trading style with question: What do you think scalping is? How would you define it? (Well, actually I start seminars asking "Are you in the mood for some trading topics or let's go to the nearest bar?" but that's irrelevant). Then I offer several possible definitions for attendees to consider:

1. Scalping means taking profit on a first uptick, as soon as any profit is available.
2. Scalping means playing marketmaker - bidding and offering, trying to pocket the spread.
3. Scalping means closing the trade within a certain, very short time period - 3 minutes, 5 minutes, whatever.
4. Scalping means taking certain size of profits -= 5 cents, 10 cents, whatever.

All of those definitions find their fans - I see hands raised when I ask who is in favor of each of them. That's where the As You Name the Boat So Shall It Float kicks in. Whatever definition you adopt, that's how you are going to trade, right? Let's see what happens with any of those above.

1. Taking profit on a first uptick. Disaster in the making, IMO. If your stop loss is defined by the chart, it's going to be more than one downtick, otherwise you are going to be shaken out by simple noise. So, your stops are going to be bigger than your profits. So much for "cut your losses short". Losing strategy for sure, as it requires you to be right practically 100% of the time. Not going to happen unless you are one of those who win a lottery each time they buy the ticket.

2. Playing the spread. This approach surfaces now and then; there was even a whole book devoted to it (not sure what the rest of the pages beyond 1st described). Sometimes I hear from some prop shop traders that their management demands this to be the only strategy employed. This approach requires some very thick stock (think SIRI) that stays practically immobile throughout the day, trading big volumes at bid and offer, making rare ticks and returning back. This strategy (actually it's more of a trick than a strategy, I shall do a post on this distinction in the future) can work now and then; it fails misreably if a stock starts actually moving as you will be forced to take couple cents stop while your targeted profit is just one cent (or even less if you undercut bid and offers). Also, what does it all have to with trading? Of course, in accordance to naming the boat idea, let's define trading as exploiting the market movement - then this approach is something entirely different as it involves no idea of reading that movement and in fact shies away from moving stocks. Not my cup of tea.

3. Closing the trade within pre-defined very short period of time. Well, this one doesn't make much sense to me. What if your stock hasn't moved within that period of time? Or moved not enough to reward you for your initial risk? Or retreated but hasn't hit your stop yet? If you decide on a 5 minutes period and stock started ticking in your favor at the 4 minutes 55 seconds mark - do you get out, even though the move you aimed for has just started? Better yet: let's say your stock sits still near the high while the market drops for 5 minutes - isn't it a great indication of its relative strength? Why would you want to get out of it just because 5 minutes passed, even though it's more than likely to move up when the market bounces? Why put yourself on a clock, as if the market cares about how many times you enter and exit and is going to reward you for just taking positions? Once again, flawed definition will lead to a flawed trading.

4. Taking predetermined small profits. OK, your stock ticks in your favor. You even aligned the profit target with your stop - let's say your setup's structure (topic for one a separate post I think) dictated 7 cents stop, your stock moved 10 cents, things look logical and meaningful now. However, are you going to take your profit now in ANY case? Even if a stock show no signs of slowing down? No pause, no pace change in buying? Sure, scalper's regret is a natural part of scalper's life, but why set up yourself for it even though the way your stock trades shows the potential for more? There will be lean times when your stops are as numerous or exceed your profitable trades, why deny yoursefl some cushion while you are hitting it right?

OK, time for a question - what's MY definition for scalping? What name did I paint on this boat?

Next post will be about that. It's too nice outside, gotta soak in some sunlight and shoot some photos.

Oh, and by the way - if you went over my articles on scalping before or own my scalping course, thus familiar with my defnitions and my way to do it - you can still make some use of the idea of the post - the way you define things will define how things work for you. As you name the boat, so shall it float.
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