Trading Style

Introducing to type of Trading

One of the most confusing aspects of the trading profession is there is no single definition of “trader”. Traders come in many different shapes and sizes, colors and varieties.

Traders generally focus on a specific class of security, mostly common stocks, but they may also trade equity options, commodity futures, financial futures, futures options, bonds, foreign markets, and so forth. The security of choice also dictates the specific market(s) on which they trade: NYSE or Nasdaq, Chicago Board Options Exchange, The Chicago Board of Trade and so on.

When trading common stocks, professionals will generally undertake one of several styles and stick only to that style. This is an important point since traders are always at the risk of being distracted by the din of ubiquitous market commentary and conflicting trading styles. Traders are constantly soul searching and questioning their own chosen approach. Some amount of experimentation is advisable, particularly at the beginning of your trading career, but deviating from a disciplined, focused approach can be disastrous later when you are establishing your style.

Some of your first decisions will determine where your niche is and what type of a trader you want to be. There are at least five distinct styles of common-stock trading, each completely unrelated to the others. The style that you choose will likely reflect your intellectual strengths, your understanding of various aspects of the markets’ operations and your temperament.

Here are the major styles of equity trading :

  • Scalping : The scalper is an individual who makes dozens or hundreds of trades per day, trying to “scalp” a small profit from each trade by exploiting the bid-ask spread.
  • Momentum Trading : Momentum traders look to find stocks that are moving significantly in one direction on high volume and try to jump on board to ride the momentum train to a desired profit.
  • Technical Trading : Technical traders are obsessed with charts and graphs, watching lines on stock or index graphs for signs of convergence or divergence that might indicate buy or sell signals.
  • Fundamental Trading : Fundamentalists trade companies based on fundamental analysis, which examines things like corporate events such as actual or anticipated earnings reports, stock splits, reorganizations or acquisitions.
  • Swing Trading : Swing traders are really fundamental traders who hold their positions longer than a single day. Most fundamentalists are actually swing traders since changes in corporate fundamentals generally require several days or even weeks to produce a price movement sufficient enough for the trader to claim a reasonable profit.

Novice traders might experiment with each of these techniques, but they should ultimately settle on a single niche, matching their investing knowledge and experience with a style to which they feel they can devote further research, education and practice. Entire textbooks are devoted to each style, although many titles such as “Day Trade Online” or “How to Get Started in Electronic Day Trading” are unclear about what type of trading they espouse.

I devote the balance of this article to explaining scalping, a trading technique which which the trader scalps small profits by exploiting the spread of a slow-moving stock. Here are articles that explore the other types of trading: momentum trading, technical trading and fundamental trading and swing trading.

The Scalper

The scalper generates trading profits from stocks that are not moving, make tiny (or teenie) profits from each trade by buying a stock on the bid and then turning around and selling at the ask. Provided that the stock does not move, scalpers can profit all day by making dozens (or hundreds) of trades, buying at the highest price at which they feel comfortable and selling at the lowest price that guarantees sufficient profit while still being attractive to buyers.

The scalper’s role is exactly the same as that of the market maker (also known as the specialist), a dealer who, by trading stock from his or her own inventory, maintains an orderly market in any given stock. The specialist is basically a scalper on steroids, as the specialist trades many times more volume per day than the average scalper. The specialist, however, is bound by strict exchange rules while the individual trader is not. For example, on the Nasdaq all market makers are required to post at least one bid and one ask at some price level, thereby making a two-sided market for each stock that they cover.

Due to the overlap of roles, the scalper is always competing with the market maker for profits. Unfortunately, the lowly scalper is almost always at a disadvantage due to the market maker’s advantages: superior execution speed, perhaps a greater knowledge of trading and the ability to “bluff” the market by placing a bid or ask that exaggerates his or her own true position.

The other factor working against the scalper is decimalization, whereby stock prices that were previously quoted in fractions are now quoted in decimals. With fractions, scalpers were always aiming for at least a sixteenth of a point in profit, also known as a teenie, equating to 6.25 cents per share. On a 1,000-share trade, for example, buying a stock at 10 and selling it at 10 and one sixteenth, a scalper would generate $62.50 in profits before commissions.

With the advent of decimalization, teenies are now toast, and the difference between bid and ask may be a single penny. On the 1,000-share trade described above, buying at $10 and selling at $10.01 generates only $10 in profits, most likely not even enough to cover trading commissions.

This is not to say that scalpers’ opportunity for profits have been lost. Depending on the stock traded and its liquidity, spreads may remain much higher than a penny, allowing scalpers to generate even more than a teenie. By increasing the number of shares bought and sold (trading 2,000 instead 1,000, for example), scalpers can compensate for any realized decline in spreads, but this comes at the expense of increasing their risk. As for any style of trading, finding a niche from which he or she can derive profits is the trader’s utmost goal. Once that niche is found, the scalper can refine his or her technique, successfully trading for pennies just as he or she was trading for teenies.

Scalping : Small Quick Profits Can Add Up

Scalping is a trading style specializing in taking profits on small price changes, generally soon after a trade has been entered and has become profitable. It requires a trader to have a strict exit strategy because one large loss could eliminate the many small gains that the trader has worked to obtain. Having the right tools such as a live feed, a direct-access broker and the stamina to place many trades is required for this strategy to be successful.

Scalping is based on an assumption that most stocks will complete the first stage of a movement (a stock will move in the desired direction for a brief time but where it goes from there is uncertain); some of the stocks will cease to advance and others will continue. A scalper intends to take as many small profits as possible, not allowing them to evaporate. Such an approach is the opposite of the “let your profits run” mindset, which attempts to optimize positive trading results by increasing the size of winning trades while letting others reverse. Scalping achieves results by increasing the number of winners and sacrificing the size of the wins. It’s not uncommon for a trader of a longer time frame to achieve positive results by winning only half or even less of his or her trades – it’s just that the wins are much bigger than the losses. A successful scalper, however, will have a much higher ratio of winning trades versus losing ones while keeping profits roughly equal or slightly bigger than losses.

The main premises of scalping are :

  1. Lessened exposure limits risk – A brief exposure to the market diminishes the probability of running into an adverse event.
  2. Smaller moves are easier to obtain – A bigger imbalance of supply and demand is needed to warrant bigger price changes. It is easier for a stock to make a 10 cent move than it is to make a $1 move.
  3. Smaller moves are more frequent than larger ones – Even during relatively quiet markets there are many small movements that a scalper can exploit.

Scalping can be adopted as a primary or supplementary style of trading.

Primary Style

A pure scalper will make a number of trades a day, between five and 10 to hundreds. A scalper will mostly utilize one-minute charts since the time frame is small and he or she needs to see the setups as they shape up as close to real time as possible. Quote systems Nasdaq Level II, TotalView and/or Times and Sales are essential tools for this type of trading. Automatic instant execution of orders is crucial to a scalper, so a direct-access broker is the favored weapon of choice.

Supplementary Style

Traders of other time frames can use scalping as a supplementary approach in several ways. The most obvious way is to use it when the market is choppy or locked in a narrow range. When there are no trends in a longer time frame, going to a shorter time frame can reveal visible and exploitable trends, which can lead a trader to scalp.

Another way to add scalping to longer time-frame trades is through the so-called “umbrella” concept. This approach allows a trader to improve his or her cost basis and maximize a profit.

Umbrella trades are done in the following way:

A trader initiates a position for a longer time-frame trade. While the main trade develops, a trader identifies new setups in a shorter time frame in the direction of the main trade, entering and exiting them by the principles of scalping.

Practically any trading system, based on particular setups, can be used for the purposes of scalping. In this regard, scalping can be seen as a kind of method of risk management. Basically any trade can be turned into a scalp by taking a profit near the 1:1 risk/reward ratio. This means that the size of profit taken equals the size of a stop dictated by the setup. If, for instance, a trader enters his or her position for a scalp trade at $20 with an initial stop at $19.90, then the risk is 10 cents; this  means a 1:1 risk/reward ratio will be reached at $20.10.

Scalp trades can be executed on both long and short sides. They can be done on breakouts or in range-bound trading. Many traditional chart formations, such as a cup and handle or triangle, can be used for scalping. The same can be said about technical indicators if a trader bases decisions on them.

Three Types of Scalping

  1. The first type of scalping is referred as “Market Making“, whereby a scalper tries to capitalize on the spread by simultaneously posting a bid and an offer for a specific stock. Obviously, this strategy can succeed only on mostly immobile stocks that trade big volume without any real price change. This kind of scalping is immensely hard to do successfully as a trader must compete with market makers for the shares on both bids and offers. Also, the profit is so small that any stock’s movement against the trader’s position warrants a loss exceeding his or her original profit target.The other two styles are based on a more traditional approach and require a moving stock where prices change rapidly. These two styles also require a sound strategy and method of reading the movement.
  2. The second type of scalping is done by purchasing a large number of shares that are sold for a gain on a very small price movement. A trader of this style will enter into positions for several thousand shares and wait for a small move, which is usually measured in cents. Such an approach requires highly liquid stock to allow for entering and exiting 3,000 to 10,000 shares easily.
  3. The third type of scalping is the closest to traditional methods of trading. A trader enters an amount of shares on any setup or signal from his or her system, and closes the position as soon as the first exit signal is generated near the 1:1 risk/reward ratio, calculated as described earlier.

Conclusion

Scalping can be very profitable for traders who decide to use it as a primary strategy or even those who use it to supplement other types of trading. Adhering to the strict exit strategy is the key to making small profits compound into large gains. The brief amount of market exposure and the frequency of small moves are key attributes that are the reasons why this strategy is popular among many types of traders.