Thursday, March 4, 2010

Ten Reason why using Scalping systems is NOT a Good Idea

There has always been something very attractive about scalping systems for most forex traders. Profits are never given back, trades are executed and left quickly and profits seem to have the opportunity to compound frequently and with great success and returns for the trader. However, people often don't realize the true characteristics of scalping systems and specially why the existence of a long term profitable scalping system is terribly unlikely. By scalping systems I mean strategies which have very small TP or exit values (below 6 times the spread). Today I am going to dedicate this post to give you the ten chief reasons why I believe scalping systems CANNOT be successful in the long term and why you shouldn't use them as part of your long term trading portfolio.

However I want to make it clear that I do know a few traders who use scalping during their day trading quiet successfuly but their strategies are methods, not systems, and they are adapted by their experience as market conditions change (note that this adaptation is not codeable due to the fact that it is extremely discretionary). They are NOT systems with strict logic-based rules which is what I will be discussing in this post. So why can't scalping systems be called long term profitable ?

Reason One. The nature of the short term movements in the market. It is true that markets do behave in a somewhat "predictable" manner in the longer time frames. Movements in the longer timeframes are the consequence of fundamental reasons and they obey mass market behavior. There are tradable market inefficiencies in the longer time frames which appear to remain constant as market conditions fluctuate because mass behavior remains fairly constant. However, the nature of the short term movements does NOT obey mass behavior, a movement of a few pips on a given currency pair can happen for many reasons. There is simply no long term tradable inefficiency associated with this because it would be like predicting when someone is going to exchange a few million dollars of one currency for another. It could be an import/export payment, a bank fund transfer, etc.

Reason Two. Any inefficiency is bound to dissappear. I have talked to several traders about this and those who use scalping totally agree with this statement. If you find any tradable inefficiency in the lower time frames which can be exploited mechanically, it will change simply because the nature of the transactions in the lower time frames is very variable. It becomes then extremely hard to find and inefficiency which remains constant during long term periods because the transaction sin the lower time frames simply do NOT remain constant, they are ever changing and they change drastically when market conditions change. Something which does not happen with wider movements.

Reason Three. The Risk to Reward Ratio. Often you will find that scalping systems try to remedy the above by using very unfavorable risk to reward ratios. It is quiet common for scalping systems to risk a lot for a little profit with a simple streak of 5 consecutive loses wiping 2 years of profitable trades in some cases. High risk to reward is the dumb way to fix a trading strategy, you are increasing your probability to be right by increasing your risk when your wrong. When the system loses its positive mathematical expectancy -due to the reasons outlined above - the system will fail, big time.

Reason Four. Live Execution Variables. Due to the fact that scalping systems work on very small exit parameters market variables related with execution become extremely important for these trading systems. Requotes and slippage become terribly important as they may account for a very significant percentage of the profit of the trading system. For example, a trading system may seem very tradable and profitable on a demo account but live trading will reveal a lot of requotes and slippage which will remove most or even all of the profitability gained by the trading system.

Reason Five. The importance of the spread. Scalping trading systems will have a hard time when dealing with market spreads due to the fact that the spread may be a very important part of the system's profits. Since demo trading and simulations do not cover the effect of spread widening it is very likely that the profitability of a scalping trading system will be GREATLY over estimated by either forward testing on demo accounts or simulations.

Reason Six. No accurate simulations. Since scalping systems take low profits they are VERY affected by one minute interpolation errors of the metatrader backtester, add to that the fact that spread widening and live execution problems are not taken into account and you will find that simulations GREATLY underestimate draw down and overestimate profitability. Of special concern is the fact that this differences will NOT be noticeable in the shor term since the winning percentage of these systems is usually high. It is common for these differences to become apparent once the system is live traded for a long period and the number of consecutive loses or the maximum draw downs starts to be seen out of proportion. Usually this underestimation of draw down is VERY important, with real draw down being 5 or even 10 times higher than that predicted by simulations and forward testing.

Reason Seven. Profits are VERY sensitive to loses. Due to the fact that the risk to reward ratio of most scalpers is so high and the fact that demo and simulations greatly over estimate the profitability of this systems it is VERY likely that the maximum draw down will increase when live trading. In most scalping systems, if the number of consecutive loses just increases by a mere 2 or 3, the system will face a wipeout. Long term profitable systems with favorable risk to reward ratios don't suffer from these problems leaving room for underestimation of loses within simulations without significantly affecting their profitability.

Reason Eight. Broker Dependency. Scalping systems act on price variations on the lower timeframes and on these timeframes the differences between broker feeds are the most prominent. Just if there is a 2 second difference between the closing of candles on each broker, results are bound to be completely different. Even more, the mere fact that the bank feed of each broker is different is likely to cause very different results between them. Add to that the fact that each broker has different live execution and spread widening and you will find that the results of scalpers are rarely reproducible and extremely broker dependant.

Reason Nine. Scalpers pay a LOT of comissions. For me one of the gratest problems of frequent trading and getting a small profit is that mainly your trading system is working FOR the broker. For example, if a trading system executes 10 positions each day, you are paying the broker 10 times the spread each day, which means that the broker is getting a great cut of your profits. Even if trading frequency is reduced, the percentage of your profits which is equivalent to spreads will be great, often 10-50% of your total profitability. Trading like this has never been sound in my opinion in the sense that the payment of comissions is maximized. If you use an ECN broker for better execution, the problem only becomes bigger due to the higher cost of ECN trading.

Reason Ten. There are NO long term profitable scalpers. The chief reason why I do not use scalpers and why I sustain that all the above reasons are perfectly valid is that there is NO long term profitable scalping system. There has been no scalping system that for the past 5 years has been able to generate profits consistently. While I have seen many scalpers come out, reach a few months or even a year or so of profitable results only to go down in flames as market conditions change or any of the above reasons appears to be true. Many people have worked on scalping systems, and yet no long term profitable system has come out. People always get excited with simulations and live trading results without taking into account ALL the above problems and this eventually leads to account wipeouts due the underestimation of loses and the use of excessive risk.

I hope that all the above reasons are convincing enough. These are the reasons why I do NOT develop scalping systems and why I don't consider them reliable systems to reach long term profitability. If you would like to learn more about the systems I develop and how I plan to reach long term profitability in forex trading using automated trading systems please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

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