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Oct 14, 2015

What Does Liquidity Have to Do with Scalping? | Best Practices

By:Sage Anderson

Periods of increased market volatility can be fruitful for traders that focus on (and excel at) "scalping."

On a recent episode of Best Practices, Tom Sosnoff and Tony Battista introduce the topic of scalping and some of the key points that traders in this arena need to consider.

Tom and Tony define scalping as a style of trading that attempts to capture small profits from shorter term price movements. A single trade in a scalping strategy is usually called a “scalp.”

The approach to scalping varies by trading product and might be executed around a core position or as its own stand-alone strategy. Scalping can be as simple as recognizing that a stock is trading in a tight range and capitalizing on that pattern by buying the lower end of the range and selling the higher end of the range.

Traders often use scalping to defend against negative theta on delta neutral, long premium derivatives positions. A position such as this will get shorter deltas when the underlying goes down and longer deltas when the underlying goes up. By "flattening" those deltas (buying or selling them based on the movement of the underlying) a trader can monetize the movement - especially if the stock moves quickly in the opposite of the original scalp.

If you buy 5,000 deltas (shares) and the stock rebounds $5, you will have considerable profit. The same as if you sell 5,000 deltas and the underlying craters.

As Tom and Tony indicate in the Best Practices episode, such trading can be highly subjective.

Some traders may choose to flatten all deltas at one point in the trading day (i.e. 2pm), while others may do so on a weekly or monthly basis.

As indicated on Best Practices, and shown below, liquid products tend to be the most ideal for scalping:

Obviously, if there isn't sufficient liquidity in a product as it trades to the most extreme points of its range, then it is much more difficult to monetize movement (i.e. make a profit).

A great example of an epic scalping opportunity was of course the well-known Flash Crash (May 6, 2010), which was an absolute dream come true for scalping-oriented long premium options strategies. Those who were lucky enough to buy during the throes of that panic were rewarded beyond their wildest dreams with the strength of the ensuing snapback.

Keep in mind, however, that the liquidity at the bottom in such unusual moves can be inconsistent at best. While the listed high and low of many stocks on the day of the Flash Crash were jaw-dropping in terms of absolute range, the number of shares that traded at the extreme points (especially the lows) was very small, especially in illiquid securities.

Tom and Tony outline some key points to keep in mind when considering a scalping strategy, as listed below:

  • Must have sufficient capital to scalp or day trade
  • Must have the discipline to stay small
  • Must set reasonable profit targets
  • Must recognize when you are in the wrong product
  • Must recognize when a move has exceeded your expectations

There are a great number of scalping philosophies and approaches that exist for a wide range of trading products. This means the approach a trader might select in any single product requires careful consideration.

We encourage you to watch the full episode of the Best Practices focused on scalping in order to further develop your arsenal of knowledge on this very important topic.

And please don't hesitate to follow up with any comments or questions at support@tastytrade.com

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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