In this article we’re going to discuss the simple method for making decisions regarding the control of risk when we’re operating a ‘scalping technique’. And for the benefit of doubt (and for the purpose of this article) we’ll be referring to scalpers as short term traders; typically these will be traders operating off low time frames, such as 3-5 minutes, as opposed to the other more historic and ‘pure’ description of a scalper which is one of lightning quick trades looking to take profit values comparative with the spread only.
The use of stops is absolutely critical when operating a short term scalping strategy as the risk has to be incredibly tightly monitored; if it isn’t then poor risk management can ruin the overall strategy. Without a doubt the risk versus return ratio becomes more critical the lower down the time frames we deal off.
There are two critical methods we can use for setting stops and controlling the risk; we can set our risk in relation to the target, perhaps 1:1 or 1:2 on a set and forget strategy, or be far more exact with our stop placement and place them near to the latest lows and highs based on the trading chart and time frame that we are trading off. For example, if we’re aiming for a ten pip net profit (after commissions and spreads cost) then on a 1:1 risk versus reward we’d take our trade, either manually or through automation and set our risk to 15 pips. Alternatively, if we wish to trade using more precision we would enter, but place our stops near the recent high or recent low taking care to avoid the contradiction of looming round numbers.
The volume of trades a scalper or day trader looks to take will naturally be significantly more than for example a swing-trend trader; therefore it’s advisable that traders look to lower their risk through correct position size management. For example if we are in the habit of taking circa five trades per day we may wish to lower our risk per trade down to 0.5% of our diminishing account size per trade.
If we only take on average five trades each trading day then our risk per day is limited to 2.5% of our account size. Theoretically our risk is then circa 12.5% per week if we were to endure a series of extreme losing days in series; each day losing five trades to the maximum value of 0.5% per trade.
It’s worth concentrating on and highlighting our overall drawdown levels at this point as we’ve touched on the subject. As we can clearly see our potential drawdown level is somewhat suggested by accident rather than design, however, most of us set arbitrary drawdowns based on ‘gut feeling’. And yet with a scalping strategy that drawdown can be far more precisely set giving a huge benefit to scalping off lower time frames versus other trading methods such as swing trading. Our likelihood of experiencing a 12.5% drawdown over the short term, whilst we fully analyse our strategy, is quite remote. We’d need to experience 25 losses in series, over the five day period at the full 0.5% loss extreme in order to reach the full 12.5% loss. And using trailing stops might mitigate our overall loss per trade to circa half the full 12.5% loss.