Scalping Trading Strategies: Event Risk and Key Technical Levels

02/27/2009 11:09 am EST

Focus: STRATEGIES

Just a decade ago, scalping was a lucrative form of trading that only pit traders could partake in. With tight spreads and a clear view of the market, the hustle and bustle of the open outcry market was perfectly suited for many quick entries and exits for five or ten basis points at a time.

Now, however, with access to the deep liquidity of the currency market along with improvements to technology and data flow, retail traders have now found their way into the trading space formerly dominated by professionals. However, entry alone does not guarantee success. In fact, for the unprepared, it merely presents a means to lose their money more quickly. Without the entire market trading in front of you, successful scalping requires a definitive strategy that takes advantage of an inefficiency or even a natural characteristic of the market that is only seen through very short time frames. In this article, we will highlight two scalping strategies for the currency markets: scalping around event risk and near key technical levels.

Event Risk Trading

For many of the uninitiated, first-time currency traders, the lure of high volatility that develops after a major economic indicator or any otherwise scheduled piece of event risk is announced offers the opportunity for quick profit. However, inexperience and the wrong strategy often lead to a quick loss. On the other hand, the presence of these indicators nevertheless has an objective impact on price action. Volatility leading up to a major event settles as traders try to avoid taking a significant position on the fear of an unfavorable surprise. During the actual release and up to a few minutes afterwards, activity often surges as the market absorbs the data. The normal retail trader's shortfall in this scenario is that they are trying to trade the data itself and are looking for a significant move in a single direction (and often without any drawdown along the way). For a scalper, there is no bias on the data aside from the potential for a jump in volatility.

Preparation begins well in advance of the actual event risk. At the beginning of the week (or even the beginning of the session), we will look for significant indicators or events considered market movers that threaten stable price action. In the image below, we have filtered the DailyFX Calendar (http://www.dailyfx.com/calendar) for all the events over the period of a week and chose an indicator that showed promise for generating price action. To present this strategy, we will make an example of the US Non-Farm Payrolls (NFPs) report. The NFP data has proven itself to be a consistent driver of volatility in the past, so we can reasonably expect activity to increase around its release (again, the actual outcome is not important).

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There are three key stages to a market's reaction to a significant economic indicator. In the time leading up to a release that could potentially turn a market or otherwise boost activity, there is often a slump in price action. Retail capital is held in the wings as traders await the actual release upon which to trade, while institutions and banks look to hedge in order to avoid the shock the market may be in for. What results from the drop in open interest is usually a tight range (sometimes imbued with a modest bullish or bearish bias). For this particular report, the chop began a few hours before the actual report was released. With a range of 10-15 points, there is little room for the traditional trader to take a position. However, these are ideal conditions for a scalper who is able to repeatedly trade in and out of the market for 4-10 points each swing with a relatively tight stop set outside of the range itself. The effectiveness of trading this phase of the strategy depends on the range and the width of the bid/ask spread.

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Typically, most speculative traders are interested in the actual release itself and plan to trade the data as quickly as they learn of the outcome. This brings with it a number of problems, including lagging data, a reaction that is inconsistent to the fundamental outcome; gaps; and a temporary widening of spreads. With such sort-falls, a scalper should clearly avoid these unfavorable conditions.

While the shock of an indicator or other event announcement can be significant; the influence on the market environment does not last for long. From our example, the surge in volatility and open spreads lasted no longer than a few minutes. Afterwards, the market found a directional bias, but overall, the swings were subdued as the market efficiently ran through preset orders or market participants otherwise took their positions off. This cowed period allows the market to develop new—or pick up old—technical formations while allowing for wider ranges.

Scalping Around Key Technical Levels|pagebreak|

For most forms of trading, speculation is essential. In contrast, scalping strategies look to remove most evidence of guesswork derived by various forms of analysis. However, through a significant increase in speculative interest, the markets have shown a more consistent reaction to these now traditional forms of market benchmarking. Just like our event risk-based scalping strategy, we can see the market often has a predictable reaction to major technical levels. There are many arguments as to why technical analysis works (it is a reflection of the crowd's behavior or their mere presence is a self-fulfilling prophecy), but one thing is for sure: These trend lines and congestion zones frequently give pause to market trends and basing patterns frequently form before an ultimate reversal or breakout. For scalpers, being able to foresee a level that can curb trends and volatility presents an opportunity.

As an example, we will look to EUR/USD, where a key support was setting in around 1.2765, which in turn led to a significant basing pattern. On the daily chart, the formation is evident. A rising trend line that began three months before gave pause to a steady bear trend. Initially, the first test of this line resulted in a sharp reversal; but additional trials confirmed the level's influence and price action would settle. Zooming into the one-minute chart, we can seen that as price action drifted down towards the now obvious, horizontal floor around 1.2765, price action would remain choppy and largely directionless. What would be considered untradeable congestion for most traders presents the ideal conditions for the scalper, with stable, tight ranges with little hint of volatility.

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On the other hand, there is always a downside to any strategy. When approaching a notable technical level, there is always the danger of a significant reversal or breakthrough. The volatility that this generates can often lead to wide spreads, gaps, and directional momentum that could generate significant losses when our aim is to be in an out of the market quickly for only a few points of profit potential. Therefore, it is essential to confirm the market's intention to yield to these technical areas rather than looking for positions on the first test.

By John Kicklighter, currency strategist, DailyFX.com

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