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Day Trading and Algorithmic Trading in Futures

Carley Garner, DeCarleyTrading.com

Whether you like them or hate them, day traders and algorithmic system traders, commonly referred to as “algos,” are here to stay.  Both groups of traders bring additional liquidity to the marketplace, which is a positive.  However, some would argue that the baggage they bring with them isn’t worth the additional liquidity.  It is no secret that highly day traded markets such as the e-mini S&P experience additional volatility throughout the last hour of the trading session as day traders square their positions.  In addition, it is difficult to deny that algo traders haven’t created a marketplace that sees severely abnormal prices at a relatively higher frequency.  Nevertheless, the new challenges posed by aggressive day traders and high-frequency traders via computer algorithms aren’t all that different from the obstacles faced by traders during the heyday of open outcry trading; the antagonists are simply wearing a different mask.

During my time as a commodity broker, I’ve noticed the strategy bringing the most traders to the futures markets is day trading.  The appeal of the strategy is the prospect of hypercharged trading profits, but it also comes with low barriers to entry, a lack of overnight position risk and, let’s face it, it is exciting.  Traders generally use the same technical indicators and oscillators for day trading as they would position trading, so if you have a winning strategy, why wait weeks for the outcome?  Instead, traders can determine whether they have what it takes to make money within a single trading day.

Most people assume day trading only entails trades that span the traditional opening and closing times of the official e-mini S&P 500 futures day session, which is 8:30 a.m. through 3:15 p.m. Central.  But that isn’t necessarily true; day trading is the practice of entering and exiting futures positions within a single trading session.  In today’s nearly 24-hour world of futures trading, a day trade might actually be held overnight.  The distinction can be found in when the position was initiated, and whether it was still open at the close of trade.  Most of the financial futures markets open in the afternoon prior to the official day session and trade through the end of the day session.  As a result, it is possible to hold a day trade nearly 23 hours per day.  If a trader is flat at the close of a trading session, anything done during that particular session is considered a day trade. 

Of course, there are some things to be aware of.  Not all brokerage firms allow their clients to trade overnight; those that do might levy a small fee for holding their position.  Further, many brokerages offer day traders discounted margin rates.  These margin discounts are frequently only granted during the exchange’s official day session (8:30 a.m. Central to 3:15 p.m. Central).  On a side note, my brokerage service (DeCarley Trading) is more liberal than most, since we grant day trading margins around the clock.  Some brokers go so far as to force liquidate accounts at the close of each day if the client doesn’t have enough money to meet the exchange’s state initial margin requirement.  Not being aware of the rules and characteristics of a brokerage is a mistake capable of destroying an otherwise attractive day trading strategy. 

Brokers’ efforts to reduce the risk of day traders isn’t because they don’t want their clients partaking in the strategy.  In fact, it is the opposite.  Day traders tend to execute a high quantity of trades, which pads the pockets of brokerage firms.  After all, the more a client trades, the more commission he pays to the broker.  Accordingly, brokerage firms work hard to promote day trading via discounted margin rates and lower commission for the highest-volume day traders.  They also encourage automated trading systems, which are inclined to be high-volume trading strategies.  Further, risk managers at brokerage firms love the idea of their clients being flat overnight.  As you can imagine, this takes much of the stress away from monitoring their client positions throughout the night.  Don’t forget, futures trade nearly 24 hours per day; you might be resting on the couch or fast asleep, but that doesn’t mean the markets are.  Global events and sentiment sway asset prices in real time without any regard to what traders in the US might be doing at the time.  Likewise, US traders buy and sell futures contracts throughout their day session without thinking twice about the Europeans, who are slumbering.

I've been a commodity broker since early 2004 and have had the privilege of having a front row seat to the game of retail trading.  Based on my observations, day trading is one of the most difficult strategies to employ successfully.  Yet with difficulty comes potential reward for those capable of managing emotions and willing to put the time in to pay their dues.  Traders able to uncover a way to make consistent profits might discover the reward is not only lucrative but also extremely convenient.  They have the ability to sleep well at night and literally choose their own trading schedule.

There is an unlimited number of strategies that day traders might opt to apply, so discussing that aspect in a single chapter is unrealistic.  Any market approach deliberated in Chapter 6, “Position Trading in Futures,” and market analysis techniques debated in Chapter 2 with respect to technical analysis can be applied to a day trading strategy.  But over the years I’ve noticed a few factors that play a big part in determining day trading success and failure.  Hopefully, you will walk away from this section with a better understanding of risks, rewards, and reality.

Common mistakes made by day traders

Day traders face modest barriers to entry, but they also face the worst odds for success.  However, much of the dismal performance by day traders can be mitigated by avoiding a few common mistakes.  Unfortunately, many of the items on this list are easier said than done because, for many, they contradict some of the advantages of day trading luring them into the markets in the first place.  Failing to take these steps shifts the odds of success away from the trader and toward his competition, the trading public.

Being undercapitalized

As a reminder, margin requirements for intraday trading are set by the brokerage firm, not by the exchange.  As previously mentioned, because brokers generate revenue based on volume commission, they have incentive to entice traders to participate in day trading strategies with low margin rates.  It isn’t uncommon for brokerage firms to advertise day trading rates for the stock indices such as the e-mini S&P 500, the e-mini Dow, and even the mini Russell 2000 for as little as $300 on deposit as a good faith deposit.  So assuming his broker was granting him a $300 day trading margin, a trader with $3,000 in a futures account could buy or sell 10 stock index futures contracts at a time, as long as his intention is to exit by the close of trade.  To green traders, this sounds like a fabulous proposition, but to those with experience it is a clear death sentence to a trading account. 

With that said, in the wake of financial crisis volatility, day trading margins have increased.  It is still possible to find $500 day trading margin rates for stock indices, but most brokerages have increased it to $1,000 or above.  This might appear to be a disadvantage and may frustrate a few traders, but the reality is a far more reasonable amount of leverage.  In addition, it is still more than enough leverage to produce large profits and losses in a trading account.  To put a $500 day trading margin into perspective, we know each point in the e-mini S&P 500 is worth $50, so with the e-mini S&P valued at 2,000 a single futures contract represents $100,000 (2,000 x $50) worth of the underlying S&P 500.  It is easy to see how a trader buying or selling an e-mini S&P contract worth $100,000 with as little as $500 on deposit could get into trouble.  If you’ve done the math, in such a circumstance the trader is putting up a mere 0.5% of the contract value to partake in the profits and losses produced. 

Day trading with high leverage is no different than spinning the roulette wheel in a Las Vegas casino.

This type of leverage doesn’t give traders an advantage; it gives them an incredible burden and a dismally low probability of success.  Adding salt to the wounds of overleveraged day traders, many discount brokerage firms offering low margins are quick to liquidate client positions should their account equity dip (even slightly) below the stated day trading margin rate.  This too adds to the likelihood of failure.  A trader with $5,000 in a futures account being granted $500 day trading margins could buy or sell as many as 10 futures contracts to enter a position.  However, if the market goes against the trade, even slightly, the brokerage will often liquidate the position.  Each firm has slightly different risk rules, but most begin to take action if the trader has less than $400 per contract.  Simply put, if the e-mini S&P moves adversely by 2.00 points, the trade might be force liquidated.  Even worse, brokers often charge a liquidation fee of $25 to $50 per contract.  Anyone who has traded the e-mini S&P before will tell you that 2.00 points are nothing more than random ebb and flow.  Without the help of luck, a trader’s entry price will have to endure more than a 2.00-point drawdown before moving in the desired direction.  Day traders using this much leverage rarely survive the trade long enough to see profits.

To review: a trader starting with $5,000 and going long 10 e-mini S&P futures, as would be allowed by a $500 day trading margin, could see his position offset by the risk managers of his brokerage firm once the loss reached $1,000 ((2.00 x $50) x 10) or 2.00 points in the e-mini S&P.  Further, the losses would be exacerbated by a forced-liquidation fee levied by the broker in an amount as high as $500.  This trader would have lost 30% of his account in a matter of minutes on nothing more than quiet market flow.  It should be clear by now that day trading futures in high quantities relative to account size or on a shoestring budget is equivalent to playing craps in Las Vegas.  Traders can increase their odds of success by mitigating leverage through sufficient account funding, or at least trading minimal quantities.  As a rule, it is a good idea to trade a single stock index futures contract per $10,000 on deposit in a trading account. 

“Investors operate with limited funds and limited intelligence; they don’t need to know everything.  As long as they understand something better than others, they have an edge.” —George Soros

Aside from the leverage factor, lightly capitalized accounts might not have the means to hold positions overnight when necessary.  This does traders a massive injustice because it prevents their trading strategy from adequately giving each entry signal the time necessary to work out.  Stock index futures might close at 3:15 p.m. Central, but that doesn’t mean your technical setup has had a chance to play itself out.  For instance, a trading strategy could conceivably trigger a sell signal an hour before the close, but the restricted time frame might not allow for the anticipated price change to materialize.  Thus, it might be crucial to hold positions into the overnight session, or even the next trading day, to give your strategy a fair chance to succeed.  Trading sessions might be on timers but markets and technical indicators are not.  If a trader is forced out of a trade at the close of the day session, it is possible he is forgoing the success of the trading signal.  Most trading strategies struggle to turn profits on 50% of trades; if you are limiting the performance of each signal to the day session, it is possible the win/loss ratio will be greatly reduced.

Overtrading

Sometimes, to their own detriment, those drawn to day trading tend to have hyperactive personalities, and this often has a negative impact on their trading results.  Rather than exercising patience, many day traders force trades out of boredom, or they rush their trading signals.  The best traders are able to develop the discipline necessary to delay entry into the market until their trading strategy returns a verified signal.  Further, trading on a whim or a gut feeling in the absence of a true trading signal according to the set parameters is generally a horrible idea.  This is because the venture is likely a low-probability prospect to begin with, but because a trade was entered on something less than a detailed strategy, there probably isn’t a sound exit strategy either.  Further, it is doubtful the trader will be able to keep detrimental emotions under wraps; on balance, if the trade is entered based on emotion not logic, the psychological stress is higher.  Poor decision making breeds more poor decision making.  If you find yourself in the midst of a string of bad decisions, it doesn’t mean you are an inept trader.  It simply means you are human; even the most experienced traders will have cold spells.  What differentiates the successful from the unsuccessful is the reaction to hard times in the market.

Traders who are overactive and trade without justification from a defined set of rules not only face potential peril from market losses, but they end up with a hefty commission bill that eats away at their trading account.  I often find myself in conversations with traders who assume if they enter a position, and the market fails to move in the desired direction right away, they will just get out.  Similarly, beginning day traders frequently express their desire to cut their losses by exiting a trade if it goes against them by a few ticks.  Although the desire for risk management is admirable, the result is relatively predictable.  This type of trading activity might not create large losses on each individual trade, but over time the transaction costs and small losses produced by the strategy can be substantial.  Day traders using overly tight leashes to manage the risk of their trades will soon find small losses eventually leading to a big loss because the market will rarely move in the desired direction without some sort of adverse price move.  A day trader cutting losses on a trade after a few contrary ticks faces a very low probability of catching a move in the desired direction.  Brokerage firms love this type of trader.  Not only do they pose little risk to the firm, they often pay a substantial amount of their account toward transaction costs. 

To prevent overtrading, most traders must adjust the way they think about the market and the day trading opportunities it presents.  Green traders look at being flat the market (being without a position) as a missed opportunity.  But traders should see it in the opposite light.  Those on the sidelines are not losing money, nor are they at risk of losing money.  In addition, they are in a much better position to take advantage of a promising opportunity should it come along.

Traders often grow bored with a quiet market and execute a small trade to lessen the pain of watching paint dry.  The problem with this is that quiet markets have a tendency to become abruptly volatile without any advance notice.  Perhaps there is a new announcement or simply a large group of stop orders triggered to force prices outside of the narrow band of trading.  In any case, a sudden change in volatility can be a painful lesson but also pose significant opportunities for those on the sidelines. 

Using stop orders

Listing stop-loss orders as a common mistake that day traders make probably has readers’ minds reeling.  The majority of trading books, courses, and forums teach traders to always use stop orders.  In fact, if you’ve ever trolled any of the popular social media trading groups, you’ve probably noticed a daily meme regarding the perils of not placing stop-loss orders.  When dealing with leveraged futures contracts and theoretically open-ended risk, you may find it preferable to protect a trading account from catastrophic losses.  However, stop-loss orders might not be the best way to accomplish this task.

In fact, in my opinion, the use of stops often increases the odds of trading failure.  Anybody who has experienced their stop order being filled just before the market reverses understands the emotional turmoil it can cause, not to mention the financial ding to a trading account.  Not only was that particular trade a failure but it can have a negative effect on trader psychology going forward, so it could affect future trades as well. 

The assumption regarding premature stop-loss triggers is that “someone” could see the traders’ stop order and went for it.  The truth is, unless a trader is executing hundreds of contracts at a time, there wouldn’t be any incentive for a trader with pockets deep enough to be capable of taking advantage of a temporary stop running price spike to pay attention to the order, let alone take action. 

Most retail traders aren’t swinging enough size to get onto the radars of the “big fish” in the market.  Thus, if a stop order is filled just before the market reverses to a favorable direction, the trader isn’t a victim; he simply placed the stop-loss order at an inopportune place.  Unfortunately, this occurs frequently.  Ironically, the very order intended to protect traders from large losses can easily become the source of the large losses.  In the end, several highly certain small losses will eventually add up to crippling amounts.  We will debate the use of stop-loss orders and offer alternative risk management techniques further in Chapter 16.

Position sizing

 

When it comes to position sizing, less is usually more.

Once again, futures brokerage firms offer “cheap and easy” leverage.  Unfortunately, novice traders often assume $500 day trading margin for the e-mini S&P is a reasonable amount of leverage. In my opinion, utilizing the maximum leverage offered is a horrible idea, inevitably leading to massive losses.  Traders are far better off trading with less leverage than is available to them.  Yet, I would venture to say that most day traders execute quantities in excess of what is ideal based on available trading capital. 

Brokerage firms are partly to blame for overleveraged futures day traders, but in the end, it is the trader’s choice whether to use it.  It is easy for traders to get sucked into the mindset that the more contracts traded, the more money made.  They rationalize, “If the trade setup is a good one, and the belief is the market will move in the desired direction, why not trade as many contracts as possible?” Regardless of the strategy, the trader never knows which ventures will be winners and which will be losers until after the fact.  Even the best trade setups can go awry.  Actually, sometimes trades that look the best on paper are the trades that fail to work.  On the other hand, trades that comply with the signals but not the trader’s “gut feeling” often work out the best.  Accordingly, a strategy of loading up on risk on any particular trade is a poor one.  The more contracts traded in a single outing exponentially reduces much needed room for error.  In this game, it is important to have some breathing room; no trading method is perfect.

In addition to the mathematical disadvantage of lower-success probabilities at the hands of being overleveraged, trading a high number of contracts adds to the emotional turmoil a trader will experience.  The avoidance of aggressive position sizing is key to keeping harmful emotions in check such as fear and greed.  If you are holding 20 contracts in a $10,000 account it would take a mere ten-point move in the e-mini S&P to blow out your trading account.  Further, it would only take a five-point move to lose 50%.  If you’ve followed the e-mini S&P intraday, you know that it can move five points in the blink of an eye.  One might argue trading such size leaves the door open to double an account on a single trade.  This is true, but the odds are highly against it.  Even the most sophisticated and experienced traders require room for error in their trading. 

How many contracts you trade at a time should be based on personal risk tolerance and available capital.  However, I recommend traders initiate a position with a one-lot of a mini stock index futures contract per $10,000, or most other commodities (gold, crude oil, the grains, currencies).  Of course, you can easily day trade ten or more times this amount with the given account size, but just because you can doesn't mean you should. 

Sound boring? Look at it this way: an average profit of $50 per day equates to $1,000 per month and $12,000 per year.  Assuming you were skilled enough to do this and started with a $10,000 account, you would have more than doubled your money in a year.  It doesn't take 10 lots of any commodity futures contract to make $50 per day, but trading 10 lots dramatically increases your odds of depleting an account.  To illustrate, a trader going long 10 e-mini S&P 500 futures stands to lose 10% of his trading capital for each point the contract goes against him.  In a market that generally sees 10.00- to 15.00-point ranges on any given day, it would be relatively easy to cause detrimental harm to a trading account by executing too many contracts. 

Failure to average price

“Maybe when it gets so bad that you want to puke, you probably should double your position.” —Martin Schwartz

Traders who follow the previous guideline of keeping position sizing reasonable to avoid the stress and risk that comes with overleveraging have the ability to price average.  Price averaging for day traders is similar to the act of scale trading for a position trader.  The premise is to nibble on futures contracts incrementally rather than buying or selling the entire desired position in a single transaction.  If the plan is to go long crude oil with as many as five futures contracts, a day trader might start with a single contract and enter limit orders to buy the other four contracts at lower prices, perhaps 20 to 40 cents lower.  In some scenarios, doing so will prevent the trader from getting all of the contracts filled, but it will also avoid being filled on all five in a declining market at what later turns out to have been an inopportune entry price.  Once the trade is deeply underwater, emotions flare, leading to ill-advised trading decisions.  Averaging the entry price will almost always lead to a more achievable breakeven point, and thus, less stress. 

Most people will tell you not to add to your losers.  Nevertheless, for those with well-capitalized accounts, I believe adding to a position as a means of adjusting your breakeven point makes sense because it increases the odds of obtaining a better average entry price.

Yet the practice of price averaging is something you should treat with care.  It doesn't mean you should buy another crude oil futures contract each 20 cents it drops against you without any other considerations.  However, if the price of oil falls substantially beneath your initial entry, perhaps that is something to consider.  Naturally, it would be wise to peel contracts off at various prices should the market turn in your favor.  If you scale into a trade, it is often best to scale out of it, too.

Day trading time frames

Day trading is a broad term that can be used to describe a nearly unlimited number of strategies.  It is conceivable that the most important decision a day trader makes when developing a trading plan is which time frame to use to chart the futures market—will the technical rules be applied to a chart using one-minute price bars, 60-minute price bars, or something in between?  There are even some day trading platforms and charting software packages that offer traders the ability to chart futures contracts using line charts produced by plotting data points for each and every trade executed on the exchange independent of time.  Others have the ability to chart price intraday using 90-minute price bars; a 90-minute chart would produce a price bar each hour and a half.  Each of these examples rely on extremes, but most traders work with something in the 10- to 30-minute range.   With that said, I prefer to look at a 60-minute chart.  In my opinion, a 60-minute futures chart provides day traders with a “bigger picture” view of price action, which can help prevent being lured into the market on noise, rather than a valid trading signal.

The exact time frame a trader chooses should reflect his personality and risk tolerance.  The shorter the time frame used, the more active the strategy will be and the higher the frequency of false signals.  Conversely, longer time frames tend to experience less activity, fewer false signals, and less deceptive price moves.  Yet, most technical trading strategies applied to charts with longer price bars will come with higher risks relative to a shorter bar.  This is because those playing with stop-loss orders will be required to place stops deeper when using a 60-minute chart than they might with a 10-minute chart.  Accordingly, there is a tendency for traders utilizing 10-minute price bars to trade larger quantities than those using 60-minute price bars.  This is because the profit and loss potential per trade is generally smaller using a 10-minute trading trigger.  In my opinion, day traders are better served trading less; consequently, using 60-minute bars help to tame the trader.  

Figure 1: Beware of signals produced by technical oscillators in early morning trade following a tame overnight session. They are generally unreliable.

Most assume all technical indicators will work similarly among various time frames and during all times of the trading day, but that isn’t the case.  Technical oscillators are least reliable in the early morning hours (Figure 42); this is because they are being calculated based on what is often tight range trading in the overnight session.  As a result, it is common to see indicators created to identify overbought and oversold market conditions produce false countertrend trading signals.  Even worse, during this time of day, the indicator can easily reach highly saturated levels, giving traders a false sense of reliability. 

Oscillator inaccuracy doesn’t have to be early in the morning; it can happen at any time.  It is far more common when using short time frames.  This is because the price data used to calculate each five- or 10-minute price bar isn’t necessarily a representative sample of the overall trend.  Some traders think such charts will provide information that the 30- or 60-minute chart won’t display for quite some time, but the overactive nature of short time frames encourages overtrading, breeds stress, and often massive losses. 

The use of a five-minute chart, relative to a 60-minute chart, will undoubtedly result in a higher number of day trading signals (Figure 43).  However, the goal of any trading strategy should be to locate and execute quality trades; focusing on quantity is a common misstep.  Because shorter time frames disguise market noise as something significant, traders will likely fall victim to a large number of false signals.  Even if the trader manages to keep losses on these high-frequency trades in check, excessive trading volume can quickly result in an expensive commission bill regardless of how low the trader has managed to negotiate his trading fees.  The bottom line is, the trader’s behavior plays a much bigger part in controlling transaction costs than the actual commission rate paid to his broker.  We will discuss the reality of commission in Chapter 15, “Understanding the Implications of Trading Cost Decisions.”

Figure 2: A five-minute chart offers day traders a higher number of trading opportunities, but the quality of the signals produced suffer relative to a longer time frame chart, such as the 30- or 60-minute.

Using charts based on short time frames, such as the five-minute chart, requires traders to place tighter stop-losses and therefore increases the odds of being stopped out of the trade prematurely.  Nevertheless, because five-minute charts are so quick to generate signals, it is paramount that the trader keeps risk in check.  This is because in low-volatility markets, the five-minute chart might generate a buy signal for countertrend swing traders with a mere 3.00-point decline in the e-mini S&P.  However, we all know the S&P 500 is capable of moving 15 to 20 points in a minute or two.  Thus, reacting to a shallow dip because the five-minute chart calls for it could put the trader into a massive losing position should he be in the wrong place at the wrong time.  On the other hand, a swing trader acting on signals produced by a 60-minute chart might not receive a countertrend trading signal unless the S&P drops 15 to 20 points.  Such a trader is still facing substantial risk, but on most days the S&P doesn’t fall more than that.  Accordingly, the odds of getting stuck with a massive loser can be mitigated. 

Stop-loss orders or weekly options?

In Chapter 16, on deliberating risk management, we will debate the use of stop-loss orders and long options to protect futures positions from losses.  It is worth mentioning in a discussion of day trading because the difference between success and failure is largely dependent on where, and how, stop-losses are used or not used.

Despite widespread chatter suggesting that one should never trade without stops, it might be the sole reason most traders lose money.  Whether traders place stops too tight or too loose, stop-loss orders elected prior to favorable market movement is a common occurrence that can devastate trading accounts as well as trader psychology.  Nothing hurts more than losing money on a trade despite being right about the market direction.

Day traders operating on the premise of quality over quantity by utilizing 60-minute charts, or perhaps even 30-minute charts, are generally aiming at higher profit targets than someone initiating positions based on five- or 10-minute charts.  As a result, it might be worth their while to skip the practice of using stop orders and instead purchase cheap protection via weekly e-mini S&P options or e-mini NASDAQ options.  If you are unfamiliar with weekly options, they are those listed by the futures exchange that expire on a weekly basis rather than a monthly basis, which has traditionally been the norm.

There are also weekly options on some commodities such as the grains and crude oil, but most day traders are applying their efforts to the stock indices due to favorable liquidity.  Those trading markets that don’t offer weekly options might look to the traditional monthly options if they happen to be expiring soon (two weeks or less).  If it is possible to get a reasonably close-to-the-money weekly expiring call option in the e-mini S&P for less than $500, it might be worth the cash outlay to protect a short futures position for the day while protecting the trade from losses without the risk of premature stopout.

This approach might not make sense for those traders utilizing extremely short time frames with small profit targets.  Obviously, if a trading signal provided by the five-minute chart calls for a long position with a profit objective of three points, it doesn’t make sense to spend five or six points to protect it.  Again, we will tackle this issue in more detail later on, but I wanted to introduce the idea here because it is relatively unconventional, despite being potentially helpful to a day trading strategy.

Believe it or not, in many instances and environments and when using options for protection isn’t feasible, I believe not using a stop order at all is preferable.  Stop-loss orders have the ability to cause more harm than good to countless traders.

Scalping futures contracts

Futures exchanges love scalpers. Their high-volume, high-frequency strategies result in massive exchange fees paid by the trader.

Because of the relatively low-profit potential per trade, scalpers are playing a volume game.  They are rarely trading one or two contracts at a time.  In order to make a scalping strategy worthwhile, it is necessary to trade high quantities of contracts in a clip.  As you can imagine, this strategy is a dream come true for those benefiting from the trading costs of a scalping account. 

Those who scalp futures contracts are seeking to profit from small market moves that seem inconsequential to most trading strategies.  Scalpers believe because a market never sits still, they can profit from the ebb and flow that occurs as each market participant buys or sells a futures contract.  In many cases, scalpers are targeting a mere tick or two in price movement.  This is equivalent to different dollar values in each commodity market but is generally somewhere around $10.  A scalp that nets one tick would provide a $10 profit to the trader before considering transaction costs, while a two-tick winner would generate $20 in gain.  However, unlike position traders or even day traders using longer time horizons, who find transaction costs to have little impact on their bottom line, a scalper could easily pay 30% to 50% of his profits to transaction costs.  Suddenly, the $10 per tick in profit per contract is cut in half. 

Contrary to what most would believe, the futures exchange itself reaps most of the rewards from the transaction costs paid by scalpers because exchange fees are constant regardless of how much commission is paid to the broker.  Yet the broker often accepts a scalping account at a discounted commission rate to help better the client’s odds of making money.  As a result, the broker often makes pennies per trade; even the most active scalpers don’t pad the pockets of his broker as much as he thinks he is.  Instead, he is probably paying anywhere from $2 to $4 per trade to the exchange.  So if you are a scalper and the CME reports better than expected earnings, you should know you played a part in that.

Most scalping strategies involve attempting to buy the ask and sell the bid in any particular futures market.  This goes against the norm.  A trader placing an order to buy a futures contract at market price would receive a fill at the current ask price, if he placed an order to sell a futures contract at the market he would receive a fill at the current bid price.  As covered in Chapter 1, the difference between these two prices is known as the bid/ask spread, and it is accepted as a normal cost of doing business in the commodity markets. 

“There is only one side of the market and it is not the bull side or the bear side, but the right side.” —Jesse Livermore

This is easier said than done.  To further illustrate, to make $50 the trader would need to execute 10 contracts and offset the scalp at a one-tick profit in addition to overcoming the one-tick hidden cost of the bid/ask spread.  On the other hand, if the trader loses two ticks in the market, the total loss on 10 contracts is a quick and painful $250 (($20 + $5) x 10)!  From a purely mathematical standpoint, it is difficult to justify a scalping strategy.  Yet some traders with quick fingers or computer programming prowess swear by it.

Scalp traders must recognize the relatively hidden transaction cost of trading built into the bid/ask spread.  A trader entering a futures contract at the market price is immediately sustaining a paper loss in the amount of the spread and the transaction costs.  For simplicity’s sake, let’s assume a scalper is paying a total of $5 per round turn for commission and exchange fees, most of which goes directly to the exchange.  By going long a crude oil futures contract, the trader is incurring a $5 transaction cost plus the spread between the bid and ask, which is generally a tick, or $10 in crude oil.  Thus, upon entry, the trader is in the hole by one and a half ticks ($15).  To turn a net profit of a measly $5, the scalper must pick up two ticks in crude oil. 

A scalper thinks he can find a way to collect the bid/ask spread rather than pay it, as all other market participants do.  To do this, he might place a limit order to sell a contract at the ask and buy at the bid to profit from market ebb and flow.  Predicting the ability to do so often stems from judging the working limit orders of other market participants via a depth of market (DOM) panel.  If you are unfamiliar with a DOM panel, it is a price ladder displayed within most futures trading platforms offering its users a glimpse into the currently working limit orders in a particular market.  For instance, it will display the best 10 bids (working buy limit orders) and the best 10 asks (working sell limit orders).  Accordingly, traders can see which prices within immediate reach of the market might have the most buying or selling interest.  An often-overlooked drawback of DOM panels is they don’t display stop orders placed by market participants, and they don’t account for market orders.  This makes sense, because a market order is filled immediately.  Nonetheless, market orders are done by the most motivated buyers and sellers and often have the biggest impact on price.

In general, if there are more sell limit orders working than buy limit orders, the scalper assumes he will be able to buy the bid as those seller orders are filled and prices are temporarily depressed.  Likewise, if a trader spots a market with more buy limit orders immediately under the market, he might believe he can sell the ask as those orders are filled and prices are temporarily boosted.

Some scalpers take the opposite approach.  They believe if the DOM panel is displaying more sellers than buyers, they will be able to sell a contract and buy it back a tick or two later after the sell orders are filled and prices have fallen accordingly.  Similarly, if the DOM panel suggests more buyers at prices near or a tick below the market price, a scalper might go long in hopes the filled orders will cause prices to tick higher. 

Once again, you can see there is more than one way of looking at market conditions and signals, and there are even more strategies attempting to exploit them.  One again, there isn’t a proper or improper way to trade.  The only judge is the bottom line of a trading account statement.  It is also worth noting that, although these two approaches to scalping involve a vastly different thought process, both methods could work.  We cannot deny that even in directionless markets, prices tick up and down as time goes on.  This is all scalpers need to potentially profit.  Scalping is a much more refined skill than it appears to be on the surface. 

Due to extremely high transaction costs and relatively aggressive position sizing, scalpers can make or lose a substantial amount of money quickly.  If your preference is to employ a conservative trading strategy, look elsewhere.  Despite low monetary risk per contract for most scalping strategies, the price action in such a narrow time frame is largely random, and high transaction costs are a difficult burden to overcome.  In addition, the practice of scalping in the traditional sense requires more nimble fingers than the average trader likely has.  In today’s world of super computers, most scalping strategies have been developed into automated, or algorithmic, trading systems.

*This is an excerpt from Chapter 7 of "Higher Probability Commodity Trading" written by Carley Garner and published by DeCarley Trading, an imprint of Wyatt-MacKenzie Publishing.

**There is a substantial risk of loss in trading futures and options.  It is not suitable for everyone!

About the author

Carley Garner

Carley Garner is an experienced commodity broker with DeCarley Trading, a division of Zaner, in Las Vegas, Nevada.  She is also the author of “Higher Probability Commodity Trading”, “A Trader's First Book on Commodities", "Currency Trading in the FOREX and Futures Markets", and “Commodity Options”, she also writes a monthly column for Stocks & Commodities Magazine.

 After graduating from UNLV as a Magna Cum Laude, Carley jumped into the options and futures industry with both feet in early 2004 and quickly became one of the most recognized names in the business.  Her commodity market analysis is often referenced on Jim Cramer’s Mad Money on CNBC, and she is a regular contributor to TheStreet.com and its Real Money Pro service.

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