Sunday, April 22, 2007

As You Name the Boat, or What Is Scalping - Part II

Before I got distracted by the great weather that lures one outside, I promised to give my definition of scalping. That's the thing with promises - sooner or later you gotta keep them. So, let's do just that.

First, some simple definitions. There is such thing as a leg of the movement. Price moves in stages, or legs - advance, pullback, advance (let's talk in terms of long position, simplicity sake). Each advance is a leg.
Another important thing to define is pullback. For our practical purposes in the case, pullback is not a simple price decline. It's important to make a distinction between meaningful price retreat and noize. We will go deeper into that when in the future we discuss such thing as setup structure. At this point let's say: pullback is a price retreat that takes price back to entry point or close to it AFTER hitting target level or close to it. Noize is that meanigless dribble - cent up, cent down - that creates an impression of activity but doesn't jeopardize any support or resistance levels. This distinction is important because if you don't make it, you will dump your trade on a first sign of price retreat, and more often than not will exit a valid trade while it's still valid. Again you can see how our definitions define our actions.

All this brings us to the definition of scalping.

Scalping is a trading approach where a trader takes the profits at the first leg of the movement, not letting the price to pull back.

As a trading style, scalping is based on assumption that the first leg will be made successfully by more stocks than the second will. Think of it as the race where all runners are going to reach 1 mile mark. Weakest ones will drop out there; some more will drop out at the next mark, and the process will continue until just one "last man running" is left. So, if you want to bet on the biggest winner, you are going to try and figure out this strongest one. Your payout will be huge if you succeed but your chances to win this bet are not great. If you, however, want smaller but surer bet, you will be betting on those that make the first mark. You will have small wins, but your percentage will be great as you will be right in a lot of cases. And that's exactly what scalping is about. A lot of smaller profits get booked; immediate gratification keeps your moral high; your account experiences slow but consistent and confident growth.

Are there tradeoffs to this style? Sure, just as to everything. Can't have yin without yang.
If your stock moves way beyond your exit point, you are going to have a case of "scalper's regret". It's going to happen often, and it's going to bother you. Gotta learn to live with that. Self-irony helps. My favorite is (after ABCD goes couple dollars and I am out with my 30 cents), "ABCD just phoned, made evil laughter sound, called me an idiot and hang up". Another drawback is, while those smallish profits add up nicely, this approach won't let you get rich quickly (I can hear howls "awww how disappointing"). This is "trading for a living" approach, not "get rich quickly" one. Sorry again, gold-diggers. More drawbacks? Try this: booking profits consistently is addictive. Don't know about you but I can live with this addiction.

If I went into tradeoff issue, would only be fair to list advantages too, wouldn't it? Let's. Steady consistent profits; high level of confidence; worry-free mind; staying liquid, ready to pounce on the next hot play or clean setup; ability to sustain you through the sideways market when there are no clear trends.

OK, one thing still remains unanswered. Where is that price level that defines first leg of the movement? How does one know first leg is about to be completed? Most often it happens around the level where profit roughly equals your initial risk. This is what we call "1:1 risk/reward ratio". Obviously, for such level to be found objectively, one needs some criteria for initial risk (you can call it stop size or stop placement, same thing). This is where we go into the territory of the setup structure, the subject of one the following articles. One quite important thing to realize at this point is, scalping is NOT a trading system - in a sense that there are no setups specific to scalping. This obviously follows from the definition for scalping that I gave earlier. If you go for profits taken at 1:1 level, then the only thing that is going to show you where that level is is your setup which defines the size of your stop (initial risk). And in this sense scalping can be utilized within the framework of any trading system - whatever setups you like, know, can read successfully, have feel for, you can use for scalping.

Although the concept of setup structure is not purely scalping related, I will try and make references to scalping applications when discuss it, to round this topic up and tie loose ends.
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