Scalping with Market Depth Lesson 2

Welcome to Scalping with Market Depth, part 2 presented by DailyFX education.

In the first video, we reviewed the benefits of short term trading and how the ability
to trade varying market conditions with no overnight exposure and tighter stops
makes this style of trading appealing. However, trading short term has its
drawbacks. Aside from those drawbacks, traders have a tool in their box specifically
designed for scalping which is market depth.

We showed you how you can use market depth in conjunction with 2 different
strategies. Additionally, setting up your platform in one click execution helps you
take advantage of shorter term moves.

In this video, we will look deeper into a style of trading called Scalping. We are
going to see what is important to the scalper when searching for trades. Also, the
money management of the trade is much different than discussed in our money
management video series. We will explain a money management technique used
exclusively for scalping. We also have another strategy to share with you and we’ll
talk about how you can use it with our market depth feature to find high probability
trades. We have a lot of ground to cover, so let’s get started.

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 Scalping with Market Depth Lesson 2

Scalping is a trading strategy that attempts to make profits on small price changes.
Traders who implement this strategy trade as often as possible, looking for small
gains with low risk.

Modern day scalping came about in the trading pits within the exchanges. Pit
traders, whose job is to make markets, scalp constantly through the day as they
match up buyers and sellers outside of the pits. Let’s consider an example to get an
idea of how this works. Let’s talk about a soybean pit trader at the Chicago Board of
Trade for example. Since the pit traders’ job is to make markets, they are able to
take advantage of the spread as the make numerous trades throughout the day. Pit
traders can profit from the spread instead of paying the spread. Here is how that
works. If the market for soybeans was 925 by 926, a trader outside of the pit,
someone like you or me, could buy or sell a contract of soybeans but we’d do so
through the trader in the pit. We could buy from the pit trader at $9.26 or sell to the
pit trader at $9.25. Let’s say we wanted to buy at $9.26. The pit trader would get an
order to buy at 9.26 from us, he would then buy a contract himself at 9.25 and
immediately sell it back to us at 9.26, clearing an immediate profit of 1 cent per
bushel.

When you factor in that there are 5000 bushels per contract, the total profit of a
successful transaction to the pit trader was $50 per contract. Then considering the
pit trader might trade 10 contracts at a time, your profit becomes $500 per trade.
In addition, if you do that 50 times a day taking care of many different clients
outside of the pit, your daily profit could be $25,000 just as an example. You can
see why so many people would be interested in getting involved in scalping.

While pit traders are market makers and are able to take advantage of the spread,
off the floor traders, like you and me, we pay the spread with every transaction that
we take. If you are trading a currency pair that has a 2 1/2 pip spread, a market
maker is immediately profitable by 2 1/2 pips by opening a trade while the off of the
floor trader, again you or me, would immediately be down by 2 1/2 pips. This
means that the pit trader only has to open a trade and immediately close it to be
profitable while the off the floor trader has to use a different approach.

Traders on the floor usually get the price they want since they‘re able to see the
market and react to the flow of orders coming into the floor, making it easier to
gauge the direction of the market.

Traders off the floor may experience slippage and unfavorable fills by simply buying
or selling at the current market price. The market constantly changes and not
always in your favor. In addition, some trading platforms require the trader to take
multiple steps to open and close a trade and you are only able to see the current
market and have no idea whether there are more buyers than sellers or vice versa

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 Scalping with Market Depth Lesson 2

ready to enter the market. While this may not be an issue for long-term traders,
scalpers need the quick execution to increase the quality of their fills.

The first thing the off the floor scalper needs is a trading platform that offers tighter
spreads, the ability to see market depth, and the ability to enter into a trade and exit
out of a trade quickly. The Active Trader Platform from FXCM is designed to meet
these needs. The Active Trader platform provides a three-dimensional market view:
Price, Available Liquidity, and Market Depth. Active Trader gives you the same view
as a market maker.

The spread, which is the difference between the buy and the sell, has a direct impact
on the profitability of the scalper. The wider the spread, the higher the cost of each
transaction. The Active Trader Platform typically offers spreads of less than one pip
for the EUR/USD. The total cost per trade is much lower than a typical platform,
allowing the scalper to exit with profits on a smaller move.

Market Depth allows the scalper to see the buying interest and selling interest to
better judge the short-term bias of the market. Markets rapidly change so
knowledge of buying and selling interest as it comes into the market gives the
scalper an edge in judging short-term momentum.

Knowing which side of the trade has an imbalance of orders allows us to use the
market depth feature of the platform to confirm our trades. To further make up the
spread, the scalper also needs a disciplined approach to trading the market and
there are many points to consider; like which currency to currency trade. There are
a couple of factors that should be weighed before deciding.

The higher the volume, the better the liquidity which means that there is more
trading at each price noted on the screen. This increases the chance of getting filled
at the price the scalper wants since there is more buying and selling done at each
price level.

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 Scalping with Market Depth Lesson 2

In addition to potentially better fills in the more liquid currency pairs, the spread is
also often tighter on these pairs. A tighter spread lowers the cost of trading which
means more money for the scalper.

The time of day is also important to the scalper’s strategy

The FX market is a true 24 hour a day market. Trading for the week starts at
5:15PM Eastern Sunday afternoon and continues to Friday afternoon at 4PM Eastern.
This allows the scalper to trade the market when it is convenient for them rather
than having to adjust to limited trading hours. But there are some key differences in
trading depending on what time of day you trade, and the scalper must be aware of
these to be able to match the trading approach with the mood of the market.

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 Scalping with Market Depth Lesson 2

Being a 24 hour a day market, somewhere around the world, a financial center is
open for business as banks and other institutions exchange currencies, every hour of
the day with only minor gaps on the weekend. The major financial centers around
the world overlap; while some markets are bringing their business day to close,
other markets around the world are just beginning to trade. Essentially foreign
exchange markets follow the sun around the world.

While currencies trade just about everywhere, the three main markets, Tokyo,
London, and New York, are the most influential because they represent almost 70%
of the world’s FX volume. Foreign exchange activity does not flow evenly.
Throughout the course of the international trading day, certain markets are
characterized by heavy trading activity in some (or all) currency pairs, and other
periods are characterized by light activity in some (or all) currency pairs. Foreign
exchange activity tends to be the most active when markets overlap, particularly the
U.S. markets and the major European markets, when it is the morning in New York
and the afternoon in London.

As Japan’s economy has dwindled over the past decade, Japanese banks have been
unable to commit to FX the large amounts of capital they once did in the 1980’s.
Despite this, Tokyo is the first major market to open, and many large participants
use it to get a read on dynamics or to begin scalping into positions.

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 Scalping with Market Depth Lesson 2

Approximately 10% of all FX Trading volume takes place during the Tokyo session.
Trading can be relatively thin. Hedge funds and banks have been known to use the
Tokyo lunch hour to run important stop and option barrier levels. Yen, Kiwi, and
Aussie pairs tend to be the biggest movers during Tokyo hours as other currencies
are quite thin and usually do not move very much.

London is the most important and influential FX market, with approximately 30% of
all transactions.

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 Scalping with Market Depth Lesson 2

Most big bank’s dealing desks are run out of London and the market is responsible
for roughly 28% of total spot FX volume. London tends to be the most orderly
market due to the large liquidity and ease of completing transactions. Most large
market participants use London hours to complete serious FX deals.

New York is the second most important market in FX, with approximately 16% of
market volume. In the United States spot market, the majority of deals are
executed between 8 AM and 12:00 PM, when European traders are still active.
Trading often becomes choppy after midday as liquidity dries up. In fact, there is a
drop of over 50% in trading activity since California never served to bridge the gap
between US and Asia.

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 Scalping with Market Depth Lesson 2

As a result, traders tend to pay less attention to market development in the

Understanding the volume in each session allows the trader to use the appropriate
strategy depending on the time of day they intend to trade. Breakout strategies
have a tendency to perform better during periods of high liquidity and volume.

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 Scalping with Market Depth Lesson 2

When the market experiences less liquidity there is an increased chance of range
bound situations. Scalpers should be aware of any economic releases due out during
this session, especially by Australia, New Zealand and Japan, but typically markets
have more of a tendency to reverse at support or resistance rather than break
through to new highs or new lows.

In addition to the strategy used, the money management approach used by the
scalper has as much influence on trading results as any other factor.

Typically, longer-term traders use a risk: reward ratio of at least 1:2. This means
that you risk one pip for every two pips you look for in profit potential. This way a
trader can be consistently profitable if they can win just 40% of their trades.

While a 1:2 risk: reward ratio is appropriate for longer-term traders since they look
for smaller losses, the scalper must take a different approach.

They take quick profits and use a wider stop. Scalpers typically use a minimum of a
2:1 risk: reward ratio to give the market room to breathe and a higher win
percentage. The idea is to win just about every trade with a small profit. So in a
scalping strategy, the trader gains 1 pip profit for every two pips risk. The risk with
this approach is that the scalper must win a higher percentage of trades just to be
profitable, but since the goal is to win just about every trade, the risk: reward ratio
is both necessary and can be effective with the proper trading approach.

When determining how much of your overall account balance to risk, long term
traders have no problem risking up to 5% of their account balance at one time. . The
number of trades taken by the scalper is only limited by the amount of time available
to monitor and trade the market. This means they trade as low as 1% of their
account balance, lowering the overall risk to the account. The trade off is that the
scalper can trade more frequently which makes up the difference.

It is also necessary to use an approach designed for scalping. The use of support and
resistance can often offer solid entries closer to the beginning of a move instead of
near the end. This can mean the difference between a winning trade and a losing
trade.

Support is a price level where buying is expected to come into the market. The
most common way to identify support is to use the previous low. The more
prominent the low, the better since that means more traders may be reacting to a
test of that low and look to buy once price is near it.

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Resistance is a price level where selling is expected to come into the market. The
most common way to identify resistance is to use the previous high. The more
prominent the high, the better since that means more traders may be reacting to a
test of that high again and look to sell once prices reach it.

But how do we know if a test of support and resistance will result in a reversal or a
breakout?

It’s impossible to know for sure, but with the use of market depth, the time of day
and the currency pair we trade, we can increase our chance of success. In the first
video one of the indicator based strategies introduced was Bollinger Bands and how
market depth complements this approach. This combination is ideal for those
traders who prefer to trade in the lower volume time period of each day. That
would be after the noon hour in New York up until the London open. Scalpers are
also encouraged to use a currency pair known for low volume during that part of the
day like the AUD/NZD. But true scalping, even off the floor, is based on high volume
and frequent trades. So we want to introduce a strategy designed to trade in the
most active part of the day's session.

Remember, the start of the London session till the lunch hour in New York is the
most active. More volume means there’s a greater chance of breakouts through
resistance or support. New buying and selling coming into the market that increases
the chance of a breakout and this time period is noted by high volume.

Here is a 1-minute chart of the EUR/USD currency pair. This trading takes place
while both the London and New York sessions are open and trading. We clearly see

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the market easily moves down through support, which is the previous low. We use
the EUR/USD because more trading is done on this pair than any other and more
trading means more liquidity.

The pattern we are looking for is referred to as an A, B, C or 1, 2, 3 move.

The idea is to sell on a move down through Point B, while placing our protective stop
above Point C. But as a scalper, we are only looking for a quick five pip profit on the
break down through support, which is Point B.

Let's take another look at the EUR/USD 1-minute chart with a different point of view.

Now we see how we use a break down through support to open our position and use
resistance at Point C for our protective stop placement. Let's take a look at a
buying opportunity.

While we are still looking for an A, B, C or 1, 2, 3 move. We want to look to buy on

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The idea is to buy on a move up through Point B, while placing our protective stop
just below Point C. But again, as a scalper, we are only looking for a quick five pip
profit on the break up through resistance, which is Point B.

Here is another 1-minute chart of the EUR/USD with an ABC move up.

This ABC move to the upside took place while the London session was open which is
the most active of the three sessions. Scalpers would buy on a move up through
Point B and place their protective stop below support at Point C.

So the keys to this breakout approach are:

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1. Pick a currency pair with high liquidity like the EUR/USD.

2. Enter on a move through Point B and look for a five pip profit

3. Place your stop beyond Point C.

4. Trade during the high volume period between the London open and the lunch
hour in New York.

There is one more step we want to add to further increase our chance of success.
We need a filter to make sure we are trading with the momentum of the market and
not against it. By adding a 200-period Simple Moving Average to our chart, we can
easily add a directional bias to our trades. We only want to look for buys when the
market is above the 200-period Simple Moving Average and look for sells when the
market is below the 200-period Simple Moving Average.

Let's look at the sell on our 1-minute EUR/USD chart to look at a complete trade.

Here we have trading during the time of the day when both the London Session and
New York session are open and trading. The market is below the 200-period Simple
Moving Average so we look for sells on a move down through support of an ABC
move. We see Point A form at the high of the move, and then from Point B we see
a reversal back up to Point C.

The market then starts to move back down towards Point B. We place an entry
order to sell one pip below support at 1.3685 and place our protective buy stop one
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pip above Point C which is at the 1.3707 level. So our sell entry is at 1.3684 and our
protective stop is at 1.3708 for a risk of 24 pips. We also enter a limit order to close
the position five pips below the entry which is easily hit in a short period of time.

Some things to keep in mind as a scalper:

1. A conventional approach may not be as effective on the shortest time frame

Even the most active time of the day in the most active currency pairs, there is still
only a certain number of trades taking place within a candle on the 1-minute chart.
Much less than a daily chart candle certainly. This means that the 1-minute chart is
not a good representation of the market mood as the daily chart. So we have to
adjust the way we look at the market.

2. Using market depth with a short term scalping strategy helps increase the
chance of success on a trade.

While the short-term swings noted by the increase in the number of bids or offers
may not have any long-term significance in the market, the information is of great
value to scalpers.

3. The risk to reward ratio used by the scalper is often opposite of the risk to
reward ratio used by a long-term trader.

4. The time of day and the currency pair used to scalp becomes a large part of the
scalpers approach to trading.

5. Having the right tools makes any job easier...as long as you understand how to
use them.

We hope you found this video helpful and we encourage you to attend one of our live
webinars on scalping with our course instructors. In the webinar, instructors will
relate to you what you have learned here to current market and trading conditions
including some patterns that may be in the process of forming right now. .
Instructors will field live Q&A on the topic of scalping. We hope you’ll come and join
us there to learn more.

Thanks for listening and we’ll see you in the webinars.

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