Forex Scalping Strategies for Active Traders

02/20/2009 11:04 am EST

Focus: FOREX

Currencies tend to fluctuate rapidly through the very short term, and it is sometimes profitable to bet that a currency may retrace sudden moves. Yet there are clearly times in which a scalping strategy will not work, and it is critical to highlight the key weaknesses of this popular trading strategy.

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 place a 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.

The chart shows that this strategy has theoretically been profitable on the EUR/USD, even on a one-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 commissions on every single trade. This may not seem like a terribly unrealistic assumption on many lower-frequency systems, but the one-minute 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 two-pip, round trip 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 and onwards. Why exactly? Extreme volatility.

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?|pagebreak|

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 US trading sessions. Second, volatility tends to hit its peak at the time that the New York and London trading sessions overlap-between 8 and 10 am 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?

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 US trading session, but we likewise note that volatility rises significantly between the hours of 8:00 and 10:00 New York time-often linked to key North American economic reports. The next attractive window occurs between the hours of 10:05 and 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 strategies-a mix of good spreads and low volatility.

What's 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.

David Rodriguez, Quantitative Analyst, DailyFX.com

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