The Scalping Manual

by Gary Norden
Welcome
Welcome to the Scalping Manual - and congratulations on purchasing something
truly unique that will benefit your trading.
This material is being published for the first time, partly because market making is in
danger of becoming a lost-art. Gary is one of the few people around that teaches it.
Tools Required
Most if not everyone reading this will be aware of my dislike of technical analysis
and charting. From my experience and research the unreliability of charting methods
shouldn’t even be a topic of discussion. The evidence is overwhelming that the vast
majority of traders who use that approach fail. Further, if you understand how
markets and their participants actually operate you will see that the assumptions that
underpin a technical analysis or charting approach are clearly flawed.
So hopefully, you won’t be surprised to learn that I don’t use charts for scalping. I
simply can’t see their value or how they provide edge. In fact, using charts will only
increase the chances that you look at markets subjectively whereas in fact we need to
view markets as objectively as possible. Further, knowing the failings of charts,
means that I can specifically target small technical traders at specific times.
I also do not use market profile, volume profile or any methods that include using
accumulated volume. For the purpose of this manual it isn’t necessary for me to
explain my views on these indicators in any depth suffice to say I think they flawed
and, as explained earlier, I must trade in the moment, in the ‘now’.
So, what should use?
Our main tool is the DOM. We only trade on (good) DOMs and we must set them of
course to one-click trading. Do not clutter your trading DOM with too much
information or columns. The main information for us on the DOM are the bids/offers
and if possible the last trade (price and if possible, volume).
I am aware that many order flow traders add various other pieces of information to
the DOM including pulled orders, accumulated volume etc. In my opinion these
pieces of information do not help my style of scalping and again. However, if you
find that some of this other information really does add edge to your trading then by
all means use it. I would never suggest that I know everything or every method of
edge, it’s just that with these other pieces of information I have never found that they
add edge for me.
All trades should be executed via the DOM.
The next tool for us is Time and Sales (or Reconstructed Tape). We want to see trade
by trade data both size and price. While we can usually see the last trade on the
DOM, sometimes the markets move too fast for the DOM to show every trade and so
we should refer to the T+S to see anything that we may not have seen on the DOM.
the quant who then has to verify them mathematically (with his math PhD) and
invariably Gary has figured out the plays in his head. He's a clever guy - you don't
make markets for options without having a good head for math. I wouldn't call him a
nerd as such - but only because he plays soccer and nerds don't play sports.
There's a lot to learn from this book - it isn't long, which is good because it gives you
areas to focus on - just not 100 of them. It is full of knowledge you will not find
anywhere else. It is the result of years of Gary being a market maker and advising to
both hedge funds and HFTs (who, as Gary explains, aren't really making markets).
This is a gem that we are all lucky to have access to. With this information and your
hard work, this information will pay for itself many times over.
Forward - Gary Norden
For decades, market making style traders made consistent profits on trading floors
around the world. Similarly, market makers in investment banks were important
profit makers for their firms.
However, after the introduction of computerized trading platforms, most floor traders
failed to implement the techniques they had previously used on the new format. We
should remember though, that the very early futures trading platforms did not look
like the ones we use today. Many platforms used very basic interfaces and this was a
significant reason why floor traders failed to transition to screen trading. On many
platforms, you simply couldn’t easily see the information required and/or they were
not easy to execute on.
Investment banks meanwhile, embarked on wave after wave of cost cutting and
exiting of trading business after the GFC as they focused more on broking revenue
and commissions – ways of sourcing revenue without the need for highly
remunerated traders and risk capital. The latter became a particular problem after the
introduction of financial reforms which meant that banks would need to set aside
increased capital if they were to engage in liquidity provision/market making.
So, steadily over the past few years the skills and techniques of market makers have
been lost. There are in fact very few of us left who really understand these skills.
People sometimes ask, ‘Are these skills still profitable?’ or ‘Aren’t they old
fashioned?’ The answer as you will see during the following pages, is that the key
principles behind market making remain valid today. With fewer traders using these
techniques, there is a strong argument that they may even have more edge now.
I should add here, that nowadays, as real market making skills are lost, techniques
which are only loosely part of market making strategies are often called market
making. For example, many HFTs are designed to essentially front-run (jump in
front) of large orders. Many traders consider this to be market making; it isn’t. As we
shall see, there is a lot more to market making than front running.
In this course, I have applied the principles of market making that I learned over
many years as a professional market maker and developed them to a scalping
technique for computerized futures markets.
Many of the ideas and techniques in this course are only available to futures traders.
Other products and platforms simply do not offer the same range of information or
transparency as futures markets. As I explain in my book An End to the Bull, futures
have significant advantages over products such as CFDs and FX platforms for private
traders in particular. I find it incredibly hard to understand why any short term traders
would want to trade on CFD or FX platforms.
Market making is not an easy style of trading to learn for retail traders. To
successfully trade in this way requires a complete change in thinking from how most
retail traders operate. Unfortunately, by now you have probably been trained to think
in terms of predicting direction, picking ‘levels’, looking for breakouts, identifying
areas of distribution or accumulation or a bunch of other ideas which frankly, don’t
help the vast majority of people who use them.
If possible, I need you to forget most if not everything you have previously been told.
I say ‘if possible’ because I know that many traders struggle to unlearn ideas and
habits.
It is important from the start that you change your mindset as to what your role is in
the markets. Previously, you may have wanted to find turning points in markets or
look for indicators or patterns that help you to predict future price movement. We will
not be doing that!
The role of the scalper/market maker is to trade as quickly as possible in and out of
the general order flow of a market. We are NOT trying to predict market direction.
You must consider yourself more of a bookmaker than a punter. It is a completely
different mindset and style.
It is essential that we trade the ‘now’ – what is happening right now. It doesn’t matter
to us what happened 30 or even 5 minutes ago. We are only concerned with right now
– right now what is this market valued at and can I buy it cheaper or sell it higher?
So called ‘levels’ that were created weeks ago or even an hour ago are not relevant to
right now. Using them helps traders to make easier decisions but it does not help
them to make better decisions. Eliminating the idea that these ‘levels’ are important,
can be very difficult for some traders but you need to do it to successfully trade as a
scalper.
Given that this style of trading and the ideas that underpin it are so different from
what you would have done before, you should expect the learning process to take
months rather than weeks. I strongly advise you not to rush the process either.
There are many ideas that need to be learned and the learning curve should be
through making small adjustments and small progress at a time. This is not a course
where one idea will be a ‘Eureka’ moment and suddenly you will be a successful
trader. You will need to build the foundations and then add to it, step by step, brick by
brick. This will take time. Some of my most successful clients have taken over a year
to really nail this style but once there they have become sustainable profitable traders.
This manual assumes that the reader already has experience trading using a DOM. I
will not be explaining the basics of how to execute trades, pull orders etc on a DOM
or how to see information on a DOM.
Finally, for those who ask if the contents of this manual are exactly what I teach
people with my one-to-one tuition, the answer is that the principles explained here are
the same. However, with the one-to-one sessions I can elaborate on some areas in far
greater depth plus show examples with recordings. I also work with clients as they
practice and progress to help them with their mistakes. There is a level of complexity
that I simply cannot explain in this format however I am confident that the
information here will be of great help to those wishing to day trade futures. This
manual is called The Principles of Scalping and that is precisely what I explain.
This manual has also been written as an introduction to this form of trading. For more
experienced market making-type traders we can also expand on some areas and add
more advanced techniques.
Finally, some topics which I briefly discuss in this course are more fully explained in
An End to the Bull. The purpose of this manual is just to be about The Principles of
Scalping, I expect readers of this to have first read An End to the Bull to understand
the basics and foundations.
I wish you all the best.
Gary Norden
Mindset & Discipline
As I explain in An End to the Bull, to become a successful trader you will need both a
winning mentality and huge amounts of discipline.
The winning mentality means that you want to learn from losing trades because you
HATE losing. You will not just continue trading after strings of losses because you
will want to work out what is going wrong before continuing. To continue trading
after a few losses without stopping for serious reevaluation, is a losing mentality.
We do not trade because trading is exciting. We do not trade because trading is cool.
We only trade if we win at trading. If you are losing at trading but still say you like
trading then you have a losing mentality. Hopefully you are reading this course
because you have been losing but hate that feeling and are driven to improve.
As I have explained, the function of a scalper is more akin to a bookmaker than a
punter and you must be ready to accept this new and very different role.
Many traders like to brag about how they bought the low or sold the top or how they
spotted a trend change. They see sell-side individuals do that on the TV and think that
is what trading is about. An End to the Bull explains why this approach is a huge red
herring that prevents retail traders from succeeding.
If you are keen to spot highs and lows or want bragging rights on picking market
moves then scalping isn’t for you.
Discipline is such a huge topic for traders it is worth a book on its own. There are
many ways a trader can be ill disciplined. For example, trading when tired; trying to
force trades on quiet days through boredom; trading when you aren’t sure your edge
is working that day; continuing to trade even though you are losing; and of course,
running losing trades.
For this course I’m not going to explain all the various ways we can be ill disciplined.
What I want to clearly state though is that to enjoy long term success as a trader you
have to be incredibly disciplined. In particular, as we are looking to make small
profits, you must exit losing trades straight away. We have no tolerance for large
losses or holding losing trades both because of the P+L pain but also because holding
a losing trade prevents us from finding new, winning trades.
With this style I aim for very high percentage win rates – around 80% with a further
10% of trades being scratched (bought and sold for the same price). To achieve this
not only requires robust trading skills but also the ability to analyze and self correct
after losing trades. In this course, I will provide you a checklist for doing this. Many
of the points on that checklist are rarely, if ever, used by retail traders.
Regarding the win rate target, I don’t reduce my targets when I teach retail traders
however a win rate of around 70% can also be very profitable IF your scratch
percentage is higher than your losers. I’ll discuss scratching later in this course.
Further, if you trade a higher tick size contract, you can also achieve good
profitability with a lower win rate but again if your scratch percentage is high. So, I
refer to an ideal profit + scratch percentage of 90%.
For example, US 30 year Bonds have a tick value of $31.25. Let’s say as a retail
trader you pay $3.50 a round trip in commissions. This would mean that a 1 tick
profit is $27.75 while a scratch trade costs you $3.50; a profit is roughly 8 times
bigger than a scratch. Whereas if you trade the eMini S+P contract with a tick value
of $12.50, your profit per tick after commissions of $9 is less than 3 times a scratch.
This means you can afford to have more scratches when you trade contracts with
larger tick sizes.
When I teach retail traders I see literally dozens of different ways they are ill
disciplined. Sometimes they will even say something like ‘I know I should be doing
X but I keep doing Y’. It is very frustrating when I see the same mistakes being
committed week after week even though I might suggest various ways to overcome
the problem. The so-called trading psychologists out there seem to believe they have
ways to improve this aspect of our trading. However, behavioral finance research
suggests that it is extremely difficult if not impossible to change some behaviors.
Certainly my experience suggests that too which is why I don’t believe that everyone
can become a successful trader.
Scalping is a higher frequency style of trading and it is essential we understand the
ramifications of that. Perhaps the most important aspect is that everything we do is
compounded by the frequency. So, small things, small adjustments, small
improvements have big effects because they are compounded sometimes hundreds of
times per year. This is both important and powerful.
Say you are trading US 30 Year Bonds for example and you can with better
discipline, identify that a 1 tick losing trade could have been scratched. The
difference in P+L for this trade is changing a loss after commissions of around $34 to
a loss of just $3. This in itself is a big change (your loss is 10x smaller). However, if
you are now able to make that change everyday i.e. x 250 it is actually worth $8,500
per year to you.
This is how scalpers improve their P+L, by making small adjustments. Retail traders
are looking for the multi-thousand dollar trades but professional scalpers are looking
for small adjustments multiplied by frequency. This is an easier method and far more
professional in nature. You will need to make this adjustment; don’t look for home
runs, look for continued and small improvements.
To conclude this section I want to reiterate that you will need to be a very disciplined
and self disciplined person to trade successfully. Myself or others can explain
techniques such as cutting losses quickly or sitting out times when you are unsure but
YOU are the person who has to implement that and implement it consistently.
I sometimes hear retail traders say ‘I don’t trade properly in practice mode because it
isn’t real money’. That is a red flag to me. Do you think top professional sportsmen
have that attitude when they practice? Of course not. They practice properly because
only perfect practice makes perfect. If you practice poorly you will play or trade
poorly.
There are many similarities between sports and trading. There are many amateur
sportspeople who play golf, shoot baskets on the weekend. However, there is a world
of difference between them and the professionals. It is the same with trading. The
gulf between amateurs and pros is huge.
If you want an example of the mindset and mentality you will require to become a
good professional trader you should think of a top sportsperson. Think, Tom Brady,
Aaron Rodgers, Rory McIlroy, Lionel Messi etc. Think about the intensity they play
at; their love of winning and desire to win; their work ethic; but also their humility. I
don’t think any of these guys have huge egos. Brady in particular is an interesting
case because it wasn’t as if he was noted as a talented player in his college days. He
was a very low draft pick but he worked hard at his game and has become one of the
greatest of all time (I say this as someone who is sick of the New England Patriots yet
I must accept the professionalism of how they go about their work).
It is harder than you might think to work at the intensity and with the focus and desire
of those kind of people but that is what you must aim for.
Tools Required
Most if not everyone reading this will be aware of my dislike of technical analysis
and charting. From my experience and research the unreliability of charting methods
shouldn’t even be a topic of discussion. The evidence is overwhelming that the vast
majority of traders who use that approach fail. Further, if you understand how
markets and their participants actually operate you will see that the assumptions that
underpin a technical analysis or charting approach are clearly flawed.
So hopefully, you won’t be surprised to learn that I don’t use charts for scalping. I
simply can’t see their value or how they provide edge. In fact, using charts will only
increase the chances that you look at markets subjectively whereas in fact we need to
view markets as objectively as possible. Further, knowing the failings of charts,
means that I can specifically target small technical traders at specific times.
I also do not use market profile, volume profile or any methods that include using
accumulated volume. For the purpose of this manual it isn’t necessary for me to
explain my views on these indicators in any depth suffice to say I think they flawed
and, as explained earlier, I must trade in the moment, in the ‘now’.
So, what should use?
Our main tool is the DOM. We only trade on (good) DOMs and we must set them of
course to one-click trading. Do not clutter your trading DOM with too much
information or columns. The main information for us on the DOM are the bids/offers
and if possible the last trade (price and if possible, volume).
I am aware that many order flow traders add various other pieces of information to
the DOM including pulled orders, accumulated volume etc. In my opinion these
pieces of information do not help my style of scalping and again. However, if you
find that some of this other information really does add edge to your trading then by
all means use it. I would never suggest that I know everything or every method of
edge, it’s just that with these other pieces of information I have never found that they
add edge for me.
All trades should be executed via the DOM.
The next tool for us is Time and Sales (or Reconstructed Tape). We want to see trade
by trade data both size and price. While we can usually see the last trade on the
DOM, sometimes the markets move too fast for the DOM to show every trade and so
we should refer to the T+S to see anything that we may not have seen on the DOM.
While chart traders watch markets on a chart (time based, so minute by minute or 5
minute by 5 minute) we MUST watch markets on a trade by trade basis. Why?
Because that’s how markets work; on a trade by trade basis. Very few (if any) trades
enter the market as, say, ‘good for 5 minutes’. Markets don’t operate on the time
basis that chart traders use.
One new trade may be vitally important perhaps due to its size or the price it traded
at. If we watch the market on a trade by trade basis and act accordingly we can act as
soon as we see this new information. A trader who uses even a 1 minute chart, may
need to wait several seconds longer before his candle or bar has been created or he
gets the indicator he needs.
Think about how many trades can take place in even just 1 minute! By analysing and
reacting on a trade by trade basis we will see things before chart traders and act
before them. This is one major way that we jump ahead of small, retail traders who
mainly use charts. To be a successful trader you don’t need to have edge over
everyone you just need to have edge over some people. Fortunately, retail traders are
consistently bad and also consistently use charts. So the edge we get from watching
and acting on a trade by trade basis should continue to exist.
By the time the chart shows a change of candlestick/bar or the indicator has changed,
we should already be in (and possibly even out) of the trade. Often, the chart traders
are our exit.
You should also note how, by using this trade by trade method, we should be trading
in the ‘now’. We should be using only the latest information, the latest trade. It
doesn’t matter to us that someone bought/sold 20 trades ago, the last trade is the one
we are interested in; the last trade may have changed where we see value.
Time and Sales also helps us to identify if there is two-way flow (discussed later) and
whether there are enough of the smaller traders. Some traders prefer to filter out small
trades (they only want to identify larger trades). The problem with that is that you
won’t get to see if there are lots of smaller traders playing too. If possible we want to
trade in and out of the smaller order flow and if the only trades right now are large
trades we probably want to stay out.
The next source of important information for us is our watch-list. As I explain in An
End to the Bull, watch-lists are vital tools for all traders. Primarily they are the best
source of dis-confirmation but for scalpers they help us to judge value (discussed in
more depth later). Context is very important for all traders and watch-lists help us to
judge context. Price traders (the vast majority of futures traders) believe they can see
everything they need with price and perhaps volume too. They believe markets only
react to price. Smarter traders, including market makers understand that this is a short
cut; markets react more to context than to price.
For example, let’s say you are trading an oil stock and it is currently trading at
$25.10. Then suddenly, the price of oil drops by 4%. We would expect this stock to
fall too. On a chart it might look like the stock has rejected $25.10 and in future,
technical traders might use $25.10 as a resistance level but in reality the stock didn’t
reject $25.10 nor should that ‘level’ be considered as resistance. The stock fell at that
moment due to the context; the falling oil price. It would have fallen too if its price
had been $25.20 or $25.00. In the future though, it is too hard for most traders to
analyse the context of that move so they have created a short cut by saying that the
stock rejected $25.10 and that is now a resistance level. For all they know, it may
have only traded 100 shares there because rarely do chartists use trade by trade
volume; they tend to use daily or hourly etc volume. (I have a video on my YouTube
channel about how scalpers shouldn’t use charts and this concept is explained further
there).
So, context is important to us as is an understanding of value. Other contracts,
correlations are essential to help us make those judgments. This does not mean we are
simply correlation traders; only using correlations will have a success rate too low for
what we want. However, we do use correlations in our judgments.
There is some personal preference for how we see correlations. Personally I like them
to be on a Quote Board and I refer to change on the day and follow how that moves.
However, some traders prefer to have their correlations on DOMs. Some react to
arrows, others react to color changes etc. The key point here is that we all react to
different things. You should set your platform up to optimize what you react to. Every
person I have taught has a different and very personal set up. It shouldn’t matter to
you how I set up my platform, you need to find what works for you. I would though,
as ever, caution against using charts for this purpose for two main reasons. First chart
bars/candlesticks are not showing moves trade by trade. Second, once you put market
information into a chart you run the risk of making more subjective judgments such
as ‘it is trending up’.
Remember, we want to only react to the latest piece of information. It doesn’t matter
if a market is in an ‘uptrend’ if the latest information suggests a down-tick we may
well want to trade that (from the short side). If you think of markets in terms of being
in a trend then you will be less likely to think objectively and in this instance may be
less likely to take a short trade. The key point is that we are scalpers not position
traders; we don’t care about trends, we just want to scalp a few ticks right now.
Saying that, we do need to be aware about strong moves (again why correlations are
important) and it can be possible that on some days (NOT the norm) we might prefer
to trade from one side. For example, on an extreme risk off day it is likely we will
judge long trades in an equity index to be more risky. It doesn’t mean we don’t take
any long trades however we may be a lot quicker to cut them or be more cautious
about them. These days are the exception though, most of the time we try to be as
objective as possible and trade what we see right now.
The next tool we need is some form of news feed. Usually, news hits markets
randomly and some news events will move markets. In addition there are news and
data events which we can plan for in advance (such as economic and company data).
Even scalpers need to be aware of news and data because obviously they can move
markets and we don’t want to be caught on the wrong side.
News can even be a source of profits for experienced and quick scalpers as we can
trade against resting limit orders before they can be pulled. However, the large
majority of scalpers do Not trade over news events.
So it is essential that you have some kind of news-feed or tool to monitor news.
The last essential tool is a method of recording and analyzing your results. Every
trader should regularly reevaluate their trading both intra-day and day after day.
Information we require are of course our win rates but also the size of wins and
losses, the percentage of scratches, how long trades and short trades are faring (i.e.
are long trades winning or losing and the same for short trades).
You should also try to make notes about the market conditions at the time and on that
day. Here we will investigate and record topics such as volatility, was it a volatile day
or was volatility high at the time of a specific trade? What was liquidity like at the
time of the trade and overall during the day (for daily reporting)? If you lost on a
trade you need to ask whether you had the opportunity to scratch it which you didn’t
take or whether it went straight to a loss. Similarly, if for example you lost 8 ticks on
a trade but had the opportunity to cut it for a 1 tick loss and missed it and then sat and
hoped, you need to be honest about that.
So we want to analyse each trade and each trade and we MUST be honest about what
we saw and did.
Journaling in this way is an important tool for all traders but particularly for those
learning new techniques. Jigsaw Trading has launched a product specifically for this task
which you may want to investigate.
Too many times, when going over client’s trading data, I have seen for example that
they made a series of short trades, all lost and the market that day was incredibly
strong. In every case, the client was unaware of this fact. This is why we need to
reassess our trading after every trade not just at the end of the day. I particularly
emphasise the need to reevaluate after a loss or scratch because we want to try and
learn and eliminate those. The winning mentality means we don’t want to commit the
same mistakes more than once so we must try to work out what went wrong with our
losing trades.
Our DOM should show us when we have positions and what they are so we don’t
always need a Position window up. Likewise for orders placed.
In terms of viewing P+L, I don’t think it is essential to track P+L. If conditions are
good and you are trading well you should just keep trading. Sure we all have some
kind of target in mind but that target shouldn’t be a reason to stop trading on a good
day. On good days we must trade as hard as we can and make as much possible. For
losing days we must keep our losses small – ideally well under 50% of a reasonably
good day’s P+L. If you do want to track your performance I would suggest you track
it in tick terms not in monetary terms. So you make ticks not dollars.
So these are the tools of our trade and yes, I have no charts on my screens. Many
retail traders and their junk educators love posting photos of them behind 8 or 10
screens as if the more screens you have the more professional you are. That’s
complete BS. I have traded for large parts of my career with one (large) screen and
the maximum I have ever used is 4. Those with 6,8,10 screens are almost always
using charts. Their game is very different to ours.
Before You Start - Due Diligence
Before any trader starts to trade a contract he/se should learn as much as possible
about it. In order to construct a good watch-list you will need to know how your
market correlates with other markets; what connections it has with the world around
it. Some correlations work on many days while others just pop up as important from
time to time (e.g. oil for bonds).
You should think about who trades the market; are there many small retail traders for
example? Or are most of the traders larger or more professional? Take a moment for
example, to think about whether the eMini S+P has a higher or lower proportion of
retail traders than 10 year Bonds?
Don’t just consider the main session, we should also think about out of hours trading.
I have many clients for example, who trade ES in the European time. In out of hours
trading such as this correlations can be a greater help but we need to be more
watchful of liquidity and two-way flow (discussed later).
Find out how and when your contract rolls over around it’s expiry. As scalpers, as
soon as we see rollover activity we should stop trading until it has completed then
move onto the next contract. Cash settled contracts tend to rollover later than
physically settled ones but you need to learn when your market does this.
Understand what news events drive your market and when they come out. We usually
don’t want to trade over news and data announcements.
Learn when public holidays are that affect your market. For example, if you are in the
US and are trading Dax you may not be aware of German public holidays.
You should be seeking information about the futures market and the underlying
market. Remember, futures are a derivative – they derive their price from the
underlying market.
Basically, learn as much as you can about your market; become an expert in it. You’ll
be amazed at how many traders lose money on silly (and avoidable) things related to
a lack of knowledge.
Using the Bid/Offer Spread
At the core of how market makers trade is the way they use the bid/offer spread. Most
retail traders are taught to buy from the offer side of the market and sell to the bid
side. They are told that if they want to get trades executed then they will need to trade
in this way. After all, they are told, in futures markets the spread is only one tick so it
isn’t much to give away right? Wrong. In reality the bid/offer spread is far more
valuable than that as market makers have understood for decades.
In fact the business model for many if not most of the more profitable firms in this
industry is based around the profit available from the spread. Firms such as CFD
providers, FX platforms etc all use the spread as a key part of their profitability.
Meanwhile, of course, the large majority of their clients lose!
For the large majority of their trades, when they want to buy, market makers will join
the bid with a limit order. Likewise when they want to sell they will join the offer
with a limit order. They will not use market orders. This is what we must do too as
scalpers.
To understand why we should do this and to prove the power of the spread let’s look
at an example.
Let’s take a random spread of 15bid/16offer and look at all possible alternatives
within a 1 tick move of there. If we hold a trade for just a couple of seconds these are
all viable outcomes and I’m suggesting there is an equal probability of each one.
If we trade like retail traders and buy 16s (whether through a limit order to buy the
offer or a market order to buy), right now if we wanted to sell we could hit the 15bid
and lose a tick or work the 16offer and scratch.
If the market moves up 1 tick to 16b/17o, we could hit the 16 bid for a scratch or
work the 17 offer which would be a 1 tick profit (if filled which we will assume you
will be for this example).
If the market moves down to 14b/15o, we could work the 15offer which would be a
loss of 1 tick. Or we could hit the 14bid which would mean a loss of 2 ticks.
These are all the possible outcomes within 1 tick of our trade.
We can see there are 6 possibilities. Here, 2 are scratches, only 1 is a profit and 3 are
losses with one loss being 2 ticks.
So, on any given price, if you buy the offer (or sell to the bid) you have just a 1 in 6
chance of profit with prices moving a spread each way. It might be worth repeating
that to yourself- you have just a 1 in 6 chance of winning!
This trade has a negative expectancy EVERY time you do it.
Obviously, traders will say that there system/indicator/pattern etc adds value and
means they have positive expectancy but most of the time this is BS. What I am
interested in, is the actual expectancy at this moment, of buying on the offer or hitting
the bid given each outcome has equal possibility (randomness).
Now let’s compare that to buying on the bid or selling only on the offer.
Back to our 15b/16o spread. Now if we buy 15s after joining the bid, right now we
could sell 15s which would be a scratch or we could sell 16s which would be a 1 tick
profit.
If the market goes down 1 tick to 14b/15o, we could work the 15offer which would
be a scratch or we could hit the 14bid and take a 1 tick loss.
If the market moves higher to 16b/17o, we could hit the 16bid for a 1 tick profit or we
could look to sell 17s which would be a 2 tick profit.
Again there are 6 scenarios but now the outcomes are very different.
Now, only 1 out of 6 is a loss. 5 out of 6 do not lose us money. 3 are profits with one
profit being a 2 tick profit.
Trading this way has a positive expectancy. Whereas buying on the offer produced
only a 1 in 6 chance of making money, buying on the bid produces only a 1 in 6
chance of losing. The contrast is stark and significant.
These are the numbers the industry don’t want you to know or think about. This is
why some FX and CFD platforms either won’t let you join bids or offers or if they
do, they won’t fill you unless the market moves completely against you (i.e. the bid
you joined has been traded through and now becomes the offer).
So the spread isn’t ’just a tick’ as most traders think. It is far more powerful than that.
It turns a trade from a 17% chance of winning to a 17% chance of losing. It turns a
trade from a negative expectancy to a positive expectancy.
That is why, those who understand this are loathe to give this edge up.
That is why so many firms exist who just make spreads and want people to trade on
them whether financial spreads, betting spreads etc. There is huge edge in making or
trading on the right side of the spread.
Remember, I am talking about trading on a random spread, I’m not even adding any
edge of understanding value right now and which side of the spread offer better
opportunities.
But there is even more to this power of the spread!
Now ask yourself, ‘how many times a session does this spread exist?’ The answer of
course, is tens of thousands/hundreds of thousands.
This creates the next source of edge and profit - FREQUENCY. The spread might
just be 1 tick but to find it’s true value we should multiply by its frequency. How
many opportunities does it provide for us?
If we compare this to say a swing trade method. Let’s say your indicator suggests a
20 tick profit (for this example we’ll assume it is possible even though it is most
probably BS). How many times a day will you get these 20 tick set-ups with your
indicator? 1? 2? 3? If you multiply the profit potential by its frequency we can see
that the spread is more powerful than these trades.
Of course, though, the industry wants you to take the swing type trades while it takes
the spread trades! The industry wants you to take the low frequency, low probability
trade with high potential (potential being the word here not probable!) profit while it
does the complete opposite.
So for the vast majority of our trades we want to enter using the limit orders on the
spread. Exit trades will also usually be entered in this way particularly for slower
moving markets.
The exceptions for exit trades are usually for two reasons. First if a trade is going
particularly badly (moving fast against you) you may just have to get out with a
market order.
The second reason, is when a trade has gone very well in your favour and done this
quickly. Particularly, in faster moving markets, if you get 2,3,4 etc tick profits very
quickly then market orders on exit can still profitable and we can choose to take the
profit by trading at market (actually we want to use a limit order to hit the bid/lift the
offer). In addition, in faster markets these profits can disappear as quickly as they
came so taking profits is not a bad thing even if here we exit at market.
The question I often get asked when explaining that we enter with limit orders is, ‘but
don’t you miss trades by sitting on the bid/offer?’ The answer of course is ‘yes’.
Retail traders then usually tell me that this would be very frustrating and they would
prefer to sell to the bid/buy on the offer or chase the market to guarantee a fill. They
are forgetting the whole point of using the spread - the expectancy and power of it. I
would usually rather miss a trade than hit the bid or lift the offer. The only time I
would trade on the wrong side of the spread is if I expect the move to be quiet large
(larger than usual). This could perhaps be after some news. Otherwise, knowing the
power of the spread, I am loathe not to use it for my trades as I know I am giving
away edge and reducing my chances of making money.
A huge part of the edge of scalping in this market makers style is the edge of using
the spread correctly.
When you know your edge you should rarely give it away. A huge part of trading is
discipline. If you don’t have the discipline to use the spread correctly, you will of
course fail to successfully implement this style of trading. Sometimes I do miss
trades, of course I do; so be it. There will be another trade soon enough (frequency).
Another upside of the frequency angle is this point; if I miss a trade there will be
another opportunity shortly. If a swing trader misses his trade, that may be it for the
day.
By using limit orders on the ‘right’ side of the spread I know that the vast majority of
the time I am ustilising the spread’s edge rather than trading on prediction.
Essentially when you lift the offer or hit the bid to open a trade you are predicting
movement. Why? Because the trade has to first clear the spread for you to make
money so there has to be some movement. Whereas, if, on a 15b/16o spread, I work a
15bid and get filled, I can place a 16offer and this would be a profit if filled. The
market hasn’t moved yet I can still profit; the sign of a trading style that doesn’t need
forecasting or market movement. I’ll refer more to this set-up later.
Queue Position
No matter what market you trade, if you want to enjoy sustained success, you need to
understand the mechanics of the market; how it works. In the old days of pit trading
for example, in order to get the best trades, a market maker needed to have a good
position in the pit and be on friendly terms with as many brokers as possible (I think I
usually failed on both these!). When futures moved to the electronic format, when
you get filled now depended on queue position (potentially a fairer method). If there
are currently 100 on the bid and you place an order to buy at the same price you will
be 101 in the queue.
Note here how on CFD and FX platforms you typically have no idea of where you
are or how and when you will get filled. As a professional trader I find this lack of
transparency to be a significant disadvantage to me hence another reason why I don’t
trade those products.
Chart traders, indicator traders and in fact the vast majority of retail futures traders
tend to set their orders to various price levels. For example, they want to buy at 15.
Alternatively, if they get a signal they might just go to market with their order. Either
way, they are not looking at queue position and this is one area where we will start to
differ greatly from them.
I will expand on the issue and use of queue position across the coming chapters but to
start with let’s look at what I hope is a clear example of its importance.
Let’s say there are a 1,000 lots on a 15bid. From a scalper’s perspective, there is a
huge difference in being number 1 of the 1,000 compared to being number 1,000 of
the 1,000.
At number 1 of 1,000 we can get a quick fill; even more importantly we can get a
quick fill by a small trader (say someone selling 2 lots). Once filled we have
hundreds of lots behind us that we can use to scratch the trade against if we don’t like
conditions after the fill.
At number 1,000 of 1,000 you cannot get a quick fill from a small trader. The only
way you can get a quick fill is if someone comes in and sells 1,000 lots and if that
happens we probably don’t want the trade! Further even if we did get a quick fill, if
there is no-one behind us, we have no-one to scratch to once we are filled.
From a market maker’s/scalper’s perspective there can be significant edge being 1 of
1,000 but no edge in being 1,000 of 1,000.
Note, this is irrespective of the price.
So a price/level trader might say something like ‘I want to buy 15s’ and will place his
bid accordingly. Whereas we might also want to buy 15s but if there are already
1,000 on the bid we will avoid the trade.
So queue position is an essential part of our decision making.
We want to get filled quickly; we want the ability to get filled by smaller traders (or
the ebb and flow of normal market activity); we want the ability to scratch the trade.
A fair question at this stage would be “but when you place an order you are always at
the back of the queue, so you don’t have anyone to scratch too?” This is true but there
are two points to make here. First, particularly in slower moving markets, it is a good
idea to see if anyone has come behind you in the queue after a couple of seconds. If
the answer is ‘no’ then you may want to pull the order. It is also the case though, that
the way we judge value, the way we trade on a trade by trade basis means we will see
opportunities before other traders. Because of this we should not be concerned with
being early in the queue or being on a short queue. It is more worrying to be at the
end of a long queue than at the end of a short queue.
This last point is one where some retail traders may feel some discomfort over.
Typically, retail traders seem to be happier being at the end of say, a 400 lot queue
than being at the end of a 80 lot queue. But depending on the average trade size of my
market (discussed next chapter) I am probably usually happier on the 80 lot bid than
the 400. The reason being that I highly value a quick fill.
This point about a quick fill might be new to most readers so I’ll explain where the
idea comes from.
For decades market makers have known the value of being filled quickly. It isn’t
enough just to get filled on your bid or offer, you also want to be filled quickly. A
slow fill could mean trouble. I’ll give a couple of examples to demonstrate how and
why the idea of a quick fill has been implemented.
First, from my time trading in the option pits on LIFFE. When brokers came into the
pit and asked for a price from the market makers, that price was live for just a few
seconds. If the price had to be relayed back via the booth to a trader in an office, this
process could obviously take some time, maybe a minute or two. If the trader on the
other end of the phone wanted to trade on that price he would instruct the broker to
do so. However, when the broker came back to the pit to trade, he would need to ask
for the price again. He could not just trade on the price given a minute or more ago.
This provided, market makers with an opportunity to change their price but the main
advantage for market makers was that they couldn’t be held to an old price and old is
anything over a minute.
Similarly, during my time on the market making desk for Convertible Bonds at ING,
when a hedge fund requested a price from me, he had literally just a few seconds to
act on it. After around 30 seconds if we had heard nothing I could call the price ‘off’
meaning he could no longer trade. There is a good reason for this, it protects the
market maker from a large player ringing round to other market makers at the same
time and trading on the highest bid or lowest offer.
So, in different circumstances, market makers had the same conclusion that after a
certain length of time, they would no longer want to trade. It wasn’t just the price that
was important, getting a quick fill was essential too. The longer you waited to get
filled the more likely it was you were going to lose. Getting a quick fill in particular
was a way to protect yourself from being hurt by a big order. We can’t eliminate that
threat but we can reduce it.
There is a good reason why this technique is not widely known about among retail
traders it is because their ‘educators’ have never traded as market makers. Only those
with proper market making experience will know of this idea.
So queue position is an essential ingredient in our decision making because it relates
to us being able to get a quick fill. We do not want to trade if the fill is slow.
If after a few seconds (the exact length will depend on the market and the session) we
have not been filled and we think we should have been (given the usual order flow),
then we will cancel the order.
But there is more to queue position! Not only do we want a quick fill on the entry but
we should also be looking for a quick fill on the exit.
Let’s say that we are trading a slow moving market, one that moves 1 tick at a time
but we are happy to take the potential 1 tick profit. We are looking to buy on the bid
and see thee are only 50 lots there which we like; it means we can get a quick fill.
However, we must also look at the offer to see how many are there. If for example,
there are 1,200 lots on the offer, we would not be able to get a quick exit. We must
apply the same rules to the exit as we do to the entry. We want to be in and out of
trades as quickly as possible. So in this above example we would not be able to trade
even though we can get a quick entry fill.
So before we trade we know we can get in and out of our trades quickly. As I shall
explain further in the next chapter, we also only need the normal ebb and flow of
business in our market to get both fills. We do not need some huge buying or selling
to drive the market our way. This gives us another huge advantage over most traders
who need lots of events out of their control to make them profitable. We should only
need the normal flow of business to take place for us to be profitable if we analyse
liquidity properly (next chapter).
There are some differences between how we approach queue position depending if
the contract is thick or thin and I will explain that in more depth in the next chapter.
But one important point that I will make here is that the thicker the contract the more
important queue position is. For contracts with 1,000 plus on the order book, queue
position will be a huge factor in whether you have edge or not. It is one reason why I
don’t trade the short end of the US curve or even US 10 Year bonds – one of the main
ways to get edge in those contracts is through queue position hence finding edge is
harder.
There is a relative factor behind queue position which I will also explain the next
chapter.
Queue position is in fact, the first part of determining value (discussed later) in a
trade from a market maker’s perspective. The reason is that unlike price traders who,
say, want to buy 15s or sell 16s irrespective of the volume on those prices, even if we
want to buy 15s or sell 16s, we will only do so if the queue position works for us. We
will not join any 15bid or 16offer because those with too much volume on them will
not provide edge; in fact they take edge away from the trade. Only those bids/offers
that provide a queue position (on the entry AND exit) that could give is quick fills,
offer us edge.
So here is another major point of difference between us and price level traders.
Finally, on queue position, a word about what if the volume on the bid (offer) you
want to join is very low? For example, we want to be in the top 150 in a slower
market but there are just 10 lots on the bid. Here the answer will depend on how
many are on the bid (offer) behind. If the bid (offer) behind has say 500 on it then we
would join the 10 lots. I’m not worried about joining a small bid in this situation; I
back myself that I am acting earlier than some traders. I would rather join a 10 lot in
this situation than join a 1,000 lot which is probably the opposite of the comfort zone
for most retail traders (Tip: I am usually happy doing the opposite of most retail
traders!)
If however, the price behind the 10 lots has, say 80 lots, then we should join the 80
lot price. Note that our effective queue position is 91 (10 on the bid/offer and 80
behind) so we are still within our 150 and so have a great chance of being filled but
would now get filled a tick better.
Liquidity & Order Flow and How it Affects our Orders
Market makers need to be very aware of liquidity and the level of liquidity will have
significant implications for their trading. In this way they are, yet again, far deeper
thinkers than chart traders whose analysis methods make no provision for liquidity.
This is an area that very few retail traders think about, so it may take some time for
you to incorporate it properly. I find that many clients struggle with this skill initially
but to master the market maker style you will need to work this out. It will likely take
time to fully learn and implement this – again, don’t rush.
(Note, it is hard in this format to fully explain some concepts as I would in one on
one sessions and this is one such topic. I would expect though that those with decent
experience of futures trading understand what I mean by fast and slow markets as
well as concepts such as thick and thin markets)
This chapter follows on from and adds to the previous chapter on queue position so
make sure you fully understand that topic before moving on to this.
The first and perhaps easiest stage of this process is to look at how many contracts on
average there are on each bid and offer. Remember, too, that this can change intra day
and certainly day to day, so this is another area we must constantly reevaluate.
Next we need to look at the current order flow. Our style means that we want to be in
and out of trades very quickly. Exactly how quickly is possible will depend on the
contract. Different markets operate at different speeds, for example the ES in Asian
time is much slower (trade by trade) than the ES is in US time. Here there is some
experience required, that is why this skill is something that will take time to master.
If we believe that for example, that 5 seconds is more than enough time to get a
quick fill, then what we need to do is to work out on average, how many lots trade in
our market in 5 seconds. Let’s say the answer to that is, 190 contracts trade on
average every 5 seconds. This means that in order to get a quick fill, we need to be no
worse than 190 in the queue. So if you want to go long but see there are already 400
on the bid, you can’t trade here. This is how we dovetail this liquidity analysis with
queue position.
Similarly, as discussed in the last chapter, if we want to buy and there are in this
example, 150 on the bid then that would be fine for us to join however, if we are
trading a slow moving market (looking for 1 tick) and the offer had 450 on it already,
then we could not join the bid for the entry trade because the exit is blocked by too
much volume.
Analyzing liquidity and incorporating that with queue position and order placement is
an essential skill of good scalpers. It is something which you may find hard to begin
with but you should look to improve on this area over time.
If trades are going wrong, one question you will need to ask is ‘was my fill too
slow?’. In a slower moving market, a slow fill is a sign that your queue position was
too far away. However, it may take time to understand what is a slow fill. When I
trade a new market I know it will take a number of trades before I can get a good
grasp of how long is too long. I can then adjust my queue position accordingly having
adjusted the time-frame I am analyzing liquidity for.
What I mean here is that, if I suspect the fill is too slow and I was previously wanting
to get filled in the first 10 seconds, I can adjust that to say, 5 seconds and then
reassess the average volume over 5 seconds and adjust queue position accordingly.
Particularly if other areas of the trade looked OK then your queue position/length of
fill could be the problem.
As we will see over the coming pages, there can be many reasons behind a bad trade.
While most retail traders tend to only adjust the entry or exit prices, there are actually
a number of other things we can adjust. Queue position and length of time we leave
our orders are among the others.
A reminder that if you expect to be filled within 5 seconds with the normal order
flow, and after 5 seconds you are not filled, then you should cancel the order. You can
then wait a few seconds and if you still like the trade and the queue positions are still
good then you can always reenter. I realize that the new queue position will be worse
than the previous one but as long as it is within your parameters it is still fine to trade.
If, during the next 5 seconds we do get the ‘normal’ volume then you can now get
filled. Doing this achieves two things. First we acknowledge that sometimes for a
brief time, liquidity drops so we cancel our order accordingly. Second, by pulling our
order after a few seconds we reduce the risk of being picked off by a large trade. I
would rather enter, pull and reenter a trade then just leave it in there for a long time.
By doing the later, you are becoming a resting limit order – or sitting duck!
You will find that this topic is one which may take more time to master. Certainly
experience and specialization help. One of my clients wrote to me how after several
months of trading his market (NQ) he not only had a much better understanding of
the liquidity aspects of his market but also the pace of the market. He watches how
many trades per minute in his market and knows that below a certain amount, it
becomes harder to trade so he stays out. Pace of market is linked to liquidity and two-
way flow too. For market makers, these are all important issues.

Adjustments for Faster/Thinner/More Volatile Markets

The liquidity and queue position analysis that I have explained in the previous
chapters is more related to slower moving markets. So we now need to look at how
we approach faster/thinner/more volatile markets.
The first point that I will make here is that whether a market is thin or thick is a
relative term; it depends on the average trade size that goes through the market.
While, clearly markets with 20 or less contracts on each bid and offer would be
classified as being thin, a market with 150 on each might be considered thin if that
market trades 500+ every few seconds. In reality many if not most equity index
futures have insufficient liquidity on each bid and offer when their underlying market
is open.
When this is the case, the market can move 2/3/4 or more ticks very quickly because
the liquidity per price is not enough relative to the volumes coming through.
For markets that move several ticks at a time, while we could examine the volume
per time period, there is an easier way for us to examine where to place our orders. In
fact, because the market, moves through several prices at a time, queue position is no
longer of such importance; if the market goes to the price where your order is, you
are more likely now to get filled (it may even go a tick or so through you).
So rather than work out a queue position per se, we adjust that to something that is
still linked to queue position but which is easier to measure at the speed these markets
move.
What we now do is to look at how much the market moved and we want to place our
orders just above (for longs) or below (for shorts) where the market was just trading
before the move.
So if our market was trading 15b/16o and it jumps to 19b/20o and other information
confirmed that going long was the trade, we should look to place a bid around 16. We
are expecting (if filled) to be able to sell at 19 or 20. If filled, we should look to exit
immediately on any bounce. So while I expect to sell 19 or 20 if the market just
jumps to 18, I will sell there. In fast markets, profits can be lost just as quickly as they
came so take what the market gives you and move on. In a slower market that only
moves 1 tick at a time, it is only possible to scalp for 1 tick. Holding any more would
essentially be position trading.
You may ask here, ‘but how will we get filled at 16 if the market just traded 19/20?’
The answer is, that for the market to move several ticks all the offers (in this case)
must have been taken out. For a short time there could be an effective vacuum in the
spread and some traders could still be trying to execute on the old price. I explain the
mechanics of how and why this happens in greater depth in my one-to-one tuition but
it is too complex to explain fully here. However, these tend to be times when retail
traders complain of ‘slippage’. Remember that when they get hurt by slippage,
someone is profiting; I have made it part of my business to be the trader who is
profiting from retail traders’ slippage.
What this means is that sometimes the market will quickly ‘sweep’ back towards the
previous price which provide a good opportunity to trade. I’m not saying this happens
every time but it does happen sometimes and when these occur they can be good
trades. One reason why they tend to be good is that we should be trading against
slower traders who are still trading the previous price using slower platforms.
There is one golden rule here though which must be obeyed in faster markets. That is
we must only accept a trade on the very first sweep. If we are not filled on the first
sweep we MUST cancel the trade. If you trade the first sweep you might be picking
someone off but if you trade the second or third, you might be being picked off.
For example, if the market jumps from 15b/16o to 19b/20o and we decide to place a
buy order at 16. If the market sweeps down straight away and trades 17 we are not
filled so must cancel the order. If it sweeps down and trades 16 but doesn’t fill us we
must also cancel the order.
In fast markets we want to get filled first time or not at all.
This keeps to the belief that we want a quick fill but in faster markets, a quick fill is
even quicker than in a normal or slower market. In very slow markets we might be
prepared to wait 60 seconds or more for a fill (if that market trades slowly and
infrequently). But fast markets are always trading, so we want a fill within seconds.
Two important points to make about order placement. First, place your order close to
where the previous two way action was. Don’t place your order in the vacuum area
(the prices in between where it was and where it now is). We should not expect the
market to go back through the area where there was two-way flow previously so this
acts as a good way to know if we are wrong.
Example, market was 15b/16o and jumps to 20b/21o. We should place our bid at 16
looking for a sweep back. If filled we can exit wherever the next up print is. I take
whatever it gives me so if the next print after my entry is 18, I’ll try to exit there. We
hope to sell at 20 but that isn’t always possible. We don’t expect the market to trade
back to 15 so if we see 15 trading that is our cue to exit, in this case for a 1 tick loss.
Sometimes it will print 15 immediately after we are filled (we don’t get the bottom of
the sweep); I give these trades a second or two to expect it to bounce. If that doesn’t
happen I exit immediately.
Second, don’t be afraid to place your orders far away from the last print. If the market
is moving 6,7,8 ticks at a time then you will need to place your orders accordingly a
similar distance away. In the same way that we must constantly analyse liquidity and
queue position, we should constantly adjust our order placement depending on how
much the market is moving. In a contract like the Dax it is not uncommon for me to
adjust my order placement 3 or 4 times an hour at least.
Example, market drops from 19b/20o to 10b/11o. Here I would place my sell order
around 18 or maximum 17. A market that can drop 9 ticks can bounce that much too.
Again we set up a good risk/reward on this trade with 19 or even 20 being our stop
(but scratch being our preferred bad exit). We expect a maximum profit of 6 to 8 ticks
with exits at 10 or 11 but we will take less if that’s what the market provides.
I see too many new scalpers keeping their orders too close in these faster markets.
They want to take too many trades and are scared of missing trades. It means that the
market often trades a few ticks through them giving them a poor risk reward profile.
It also means their losses can be 3 or 4 ticks. If you are trading a faster/thinner market
and you find your profits are only 1 or 2 ticks but your losses are 3 or 4 or more then
your orders are likely to be too close.
Don’t be afraid to miss trades – particularly in the early days when you are still
learning.
Remember too, that we don’t get all of these types of trades or even most of them. We
are likely to cancel more than we get filled. But when we do get filled they tend to
offer good risk/reward and high percentage win rate.
One other point, if you market is just continuing to jump higher (or push lower) in
wave after wave – don’t chase it. This is one way business and you either won’t get
filled or we get long at the top (short at the bottom).
Example, market was 15b/16o and jumps to 20b/21o. We place a 16 bid but there is
no sweep. Market then jumps again to 25b/26o and then jumps again to 30b/31o. It is
dangerous to chase these one way moves. If/when you get filled it will likely be bad.
If I chase the second move by placing say a 20bid, I will leave this in for only a very
short space of time before pulling it. Sometimes we just have to leave markets alone;
this is one time to sit out until business goes two-way again.
I must add, that in all these recent examples, we only place a bid or offer after a move
IF we see other evidence from correlations etc. Just chasing each and every move
when there is no other supporting information is just a form of gambling. If you chase
each move and each sweep you will overtrade and have a much lower win rate. We
want higher probability set ups.

Value
Having explained how to place orders, I now need to explain why we place orders.
What makes us decide to go long or short at any given time?
I call this topic understanding value. The job of a market maker is to understand the
value of his contract right now and then work out can he buy cheaper or sell higher
using the spread, right now. The reality is that we can’t or won’t trade on most
spreads because we won’t always know the value but there are still hundreds, perhaps
thousands (if we were fast enough) that do offer us opportunity.
I have already explained one input into value, namely queue position. For slower,
thicker markets if there are already too many on the bid or offer we can’t trade there.
From a value/edge perspective they offer us nothing; in fact they take value and edge
away. So for these markets, the first thing we do is to scan the bids and offers to see if
we can trade at the current price. If the answer is ‘no’ , we have to wait until this
situation changes. Orders get pulled and traded against so this is a constantly
changing environment.
The next input into value is the need for and use of correlations.
There is a big difference between price and value. You cannot determine the value of
something just by looking at its price. You still can’t judge the value of something by
analysing its volume.
Here’s an example. I tell you there is a small Ford family car that they sell for
$20,000. You know the price. I now tell you that they sell 1,000 of these cars each
month. Now you know the volume. But if I asked you now, ‘is this car good value?’
You cannot provide an answer with the information provided.
Value is a relative concept. If I now told you some additional information; namely
that Toyota sell a very similar car and it also sells for $20,000. Now you can judge
whether the Ford is good value; you would probably (hopefully) judge that it is fair
from a valuation perspective. In fact we all probably use this type of analysis
whenever we buy big items such as cars, computers etc. But when people trade they
usually forget this.
In trading to make these judgments of value we need to use correlations. We must
research our market and find which markets correlate well with it. As I explain in An
End to the Bull, both positive and inverse correlations are best if it is possible to get
both.
Remember though, that correlations are just one input and we shouldn’t trade each
uptick or down-tick in a correlation (correlations are rarely near to 100%). However,
we use them as a guide to which side of the spread we would want to trade from.
They are one of a few inputs into value, don’t become just a correlation trader (their
success rate is too unreliable alone)
Value can change even if the price doesn’t; this is important to understand for our
trading. If we go back to the car example. If Toyota cut the price of their car to
$18,000 and the Ford car remains the same, if I now asked you if the Ford is good
value the answer has changed. The Ford is now expensive. But its price hasn’t
changed. However, if we look at how markets work, we would expect fewer people
to buy these expensive Fords now and so eventually Ford will have to drop its price.
This is the mechanics of a market.
There is one huge point to make here and it goes to the heart of a market maker’s
edge. By watching these prices, trade by trade and using this concept of value, we
would know as soon as Toyota drops its price, that the Ford is now expensive.
However, technical traders won’t see this; it isn’t on the graph. Only when, over time,
the volume drops off and then Ford cut the price will they see that $20,000 is
expensive. So, they will always see this type of information later than us. It is the
same for technical traders in our markets. Watching trade by trade data and using
correlations to help judge value, will help us to get ahead of the technical traders.
Two big points here; first, most retail futures traders use technical tools; second and
following on from that, we don’t need to have edge over everybody in a market, we
only need to have edge over enough people. As long as most retail traders continue to
look at markets in the way they do, we should continue to have this edge. With the
prevalence of technical analysis in the ‘education’ business, I don’t expect things to
change.
Back to using this to trade. Essentially what we want to know is that our contract is
trading here at point X with other markets trading at points Y and Z. If the other
markets say, drop sharply we may expect ours to as well. By doing this, we
understand the context of the current price action. We don’t simply say that our
contract is good value at 15. Instead, we say that 15s are value with other, correlated
markets at X and Y. If the context changes we don’t simply expect 15s to be a ‘level’.
This is a huge area of difference between us and those who use levels. Anyone who
uses support and resistance levels and any other form of information that does not
include context, will be making very simplistic decisions. Understanding context
helps us to make more robust decisions and is one way that value traders are
differentiated from price traders.
Another point on using correlations. We must watch them tick by tick, trade by trade.
Each new uptick is a potential new reference for value. So, for example, I use the
change on the day figure to watch correlations (some people use DOMs for them). If
a contract is +16 on the day and then prints +15, this is a downtick and a potential
signal for value to move lower. Here, the market is still up on the day but it is now
ticking lower. Remember, we must trade the ‘now’ – what is happening right now.
Here, right now, our correlation is ticking lower so that is the important information.
I should additionally add that we only use correlations when it is clear they are
correlating well with our market. Some days these correlations are strong and some
days they are weaker. We must be able to judge day by day and intra-day how strong
these are and if they are weak we will not be able to use them. Hence on those days
our decision making is more difficult and we may even decide not to trade. Strong
correlations are an excellent tool for traders.
The final part of the jigsaw as far as value is concerned relates to what is the standard
economic definition of value; namely the value of a product is the price that people
are willing to pay for it. For our trading this means watching the market trade by
trade and determining where the heaviest volume is (for slower markets). If for
example, the market is trading like this:
15x 5 lots, 16x 50 lots, 15 x 2 lots, 16x 30 lots etc
we would determine that 16 was value in this context.
Market makers are essentially trying to buy cheaper than others are buying and/or sell
more expensive. Before we buy 15s we want to know that there are others who are
paying 16 (same but other way around for short trades). We do not want to buy 15s if
we have not seen anyone else buying 16s. Otherwise who will we be selling to or
buying from? By doing this, we are not buying or selling on hope; we know when we
buy there are others (of decent size) who are paying more and similarly when we
short we know there are decent size traders who are selling lower. Note that for this
purpose, we do not care what the 1 lot traders are doing; they do not tell us value.
Remember you have to add this to the use of the spread to see how we get filled. So
an example of our thinking would be like this.
If the market is 15b/16o with bigger trades at 16 and correlations suggesting a move
higher and the size of the bids and offers suggest we can enter and exit quickly, then
we would look to place a 15bid looking to buy there as part of the two way business.
Remember too that we want/expect a quick fill. So if we haven’t been filled when we
had expected, we must pull the order.
Note the number of pieces of information that we require in order to place an order.
We are aiming for high percentage win rates so we seek out trades where a number of
factors are in our favour. The spread already builds in it some edge but now we are
buying 15s when we know that others are paying 16 and we are doing so with
correlations supporting that decision to buy and with liquidity suggesting we can get
in and out quickly. If you add all this up together, it equates to a lot of edge and
positive information for our trade.
I should add here, that for the purpose of this manual which is aimed at new market
making scalpers, I am explaining one style of trading, namely only following the
current direction from all markets. Experienced scalpers can also look to fade certain
moves however, fading is always a more complex technique and to start with I don’t
want traders to try it.
If you have conflicting evidence, some points are pointing to buying but others are
not so supportive, then we shouldn’t trade. If you choose to trade with only some
supporting evidence, it would be what I term an ‘aggressive’ trade. If the trade fails
you can leave that trade alone for the rest of the day. However, sometimes traders
back their instinct and I’m not totally against this as long as you respond accordingly
if the trade fails.
So far, we have looked at slower markets but how do we judge the current value for
faster markets which are jumping around? Obviously we can’t use the same method
of trying to work out where the heavier volume is because of the jumping. So the
method we use is quite simple (it has to be due to the speed we are trading at). Simply
we use the last trading price. So if a market trades 15 then jumps to 18, 18 is our new
reference point for value. Note we still use correlations too for that part of the value
equation. Also remember that in faster/more volatile markets we will be placing
orders further away from the last value print.
It should be noted that this form of value analysis is more simplified than the other
method and so will not be as reliable. So be wary of trading each uptick/downtick
with these faster markets. I’ll talk about this more in the chapter on trading the chop
versus trading moves. It is very easy to overtrade fast markets believing that each
new trade is a new value. We still want to make sure the correlation is supporting our
trade and if there is conflicting evidence or no evidence from the correlation, we
shouldn’t trade.
As with everything in this course, do NOT use this value analysis with any form of
technical analysis or volume analysis or indicator. Ideas such as support and
resistance levels, accumulation, absorption etc are NOT ideas to be used by market
making futures scalpers.
How We Set Up Trades & Scratching
I now want to recap the ideas from the last few chapters and put them together into
what a trade should look like when it is filled.
We start off by judging liquidity and value. These require a few pieces of
information. If we have decided to join the 15bid bid on a 15b/16o spread with a
good queue position we should expect to get a quick fill. If we are correct in our
judgment of value we should also expect others to come in behind us on the 15bid.
So, when we are filled (in a slower market) we are buying at 15 and we expect the
market to still be 15b/16o after our fill. This is the perfect set up that we are looking
for. It means at the time of our fill we have set up a profit or scratch scenario. We are
long at 15, we will then immediately offer 16 to make a tick but if 15s start to trade
and look like trading out then we can scratch the trade. If we are filled by small
traders then it is very possible to achieve this set up.
If you find that you are filled by a bigger order and after being filled at 15 the market
is 14b/15o, if it shows no sign of immediately going back 15b then you would work
to scratch the trade but not wanting to miss the maximum 1 tick loss of selling 14s. If
this type of scenario continues to happen to you then either your judgement of value
is slightly out or you should look to place your order a further tick away (at 14) while
still trying to get a quick fill.
So we try to set up trades that offer us a profit or scratch set up. Most retail traders set
profit targets and stop loss limits; for them every trade is either a win or a loss.
If you are to make the transition to become a more professional style trader you must
change you mindset. You must target trades that offer a profit or scratch set up.
Change your mindset from win or loss, to win or scratch. The difference between
losing even just 1 tick on a trade and scratching the trade will be significant when you
factor in how many trades we do. With scalping, everything we do is compounded
perhaps hundreds of times a year. So learning to scratch rather than take a 1 tick loss
can be another vital step to profitability. It can literally be worth thousands of dollars
per year.
True professional futures traders have always understood the importance of
scratching. In fact in the floor days, we got rebates from the exchange for scratch
trades because they knew we did so many and it was a vital part of providing
liquidity.
When I am studying the trading stats of my clients one stat I look for is to see a
higher number of scratches than losses. It tells me two things. First that they are
setting up trades correctly. Second, they are disciplined enough to exit at the scratch.
It’s one thing to set up a trade as a profit or scratch but then you must have the
discipline to exit at the scratch if it looks like the trade hasn’t worked as you wanted.
Remember that we expect to exit the trade quickly so if you are still in the trade after
you thought you would be out of it, then you should be looking to exit.
For faster markets that are jumping around a few ticks at a time, whether you have
the opportunity to scratch will depend on your order placement. If your orders are
placed correctly then you should still have the opportunity to scratch. If you find that
you never get the chance to scratch and your bad trades are always 1 or 2 or even
more ticks offside, then your orders are being placed too close for the current
conditions.
By moving them further away you should eliminate these bad trades which is what
we usually want to do even if it means missing a couple of good ones. The reason is
that we are aiming for a high percentage win rate which itself provides the
opportunities to scale up a bit. We don’t want to become big traders but if we have a
high win rate then we would like to increase our size. In my opinion win rates of 55%
or 60% are too inconsistent for scalpers to scale with.
Faster Markets - Trading the Chop vs Trading Moves
Earlier, when discussing order placement in faster markets I explained the technique
of placing orders a few ticks away. We should use this technique after value has
moved. For faster contracts though, it is important to differentiate between moves and
just the normal ‘chop’ that takes place.
Faster/thinner markets (Dax etc) often chop around. For example, 15...18..16...18..15
etc This type of action is not a move it is what I call the chop; just chopping around.
More aggressive market making style scalpers can decide to trade this chop by
placing bids around 15/16 or offer around 18/17 (depending on which way you want
to enter the trade from) and looking to make around 2 ticks per trade. On the face of it
these can appear to be easy trades and at first they can be.
Typically this action might be accompanied by no discernable movement in the
correlations that we are using. So with nothing much happening we can decide to
trade in and out of the chop order flow using the spread. Note, that even though the
‘real’ spread might be 16b/17o, the market might continually trade 15 and 18 due to
the thinner nature of these markets. The ‘effective trading’ spread is really 15b/18o.
The problem with this is that in these types of markets (Dax, NQ etc) we know at
some point there will be a move; it won’t stay chopping here for ever. Now, if for
example, we have a 15b in the market and the next move is a jump higher, we won’t
get filled. However, if the next move is a drop we will get filled but of course we
won’t like this trade. So, if, when trading the chop, the market moves, you can only
get bad fills. The loss might be 5 or more ticks. So you have to weigh this possibility
up against how many times you think you can scalp the chop.
Even trading the chop though, we should still be pulling orders if not filled very
quickly so this discipline may help us to avoid getting caught. But it is still
reasonably inevitable that we will get caught sometimes. So it is up to each trader to
decide if he wants to trade the chop.
The alternative is to leave the chop alone and only trade after a ‘move’. Having
traded 15...18...16...18...15 when we finally get a move, say to 10, if this is backed
by similar moves in our correlations, we would look to place a sell order around
14/15 looking to short any sweep higher. Of course, we may not get filled, but this is
the situation we want to try for when markets move.
So, trading after moves is more defensive way to trade whereas trading the chop is
usually more aggressive. However, on less volatile days, we may look to trade the
chop more as the lower volatility will mean there are less moves to trade and the
possibility of getting badly hurt trading the chop are reduced. Conversely, on more
volatile days we should not trade the chop and look instead to trade the moves.
Two-way Flow
As stated earlier, market makes are students of liquidity and base many of our
decisions around liquidity. Another vital aspect of this relates to two-way flow in
markets.
Two- way flow means there are sellers hitting the bid and buyers lifting offers at that
moment. For market making style scalpers it is essential that we see this type of
activity when we trade.
The opposite of two-way flow is one way trading. For example, if a market is rallying
and buyers just keep lifting the offer with few or no sellers hitting bids.
It should be evident that in times of one way action we cannot get in and out of a
trade quickly. Therefore we should avoid these times. If, for example, a 15b/16o
market is trading 16,16,16,16,16,16,16 – while we can see that value is 16, without
any 15 prints we cannot get filled on a 15 bid. You may try a 15 bid for a very short
time but if 16s only keep trading you must pull the order. In these types of one way
markets there are two main possible outcomes. First, we don’t get filled at all.
Second, if/when we do get filled we probably won’t want it. In these types of
conditions when a seller finally arrives it is probably a large seller and many of us
will get hit together and be scrambling to get out.
So we must learn to recognize whether our market is trading two-way or one-way.
Typically, markets where the underlying contract is open, tend to have two-way
business but this will not always be the case. However, if you are trading an out-of-
hours time and even sometimes in bond markets, business can get too one-way at
times so watch out for this.
If we think about it, when there is two-way flow we should be wanting to trade
because our main tool, the spread, works well in that time. In a 15b/16o market that
prints – 15,16,15,16,15,16,15,16 – either buying 15s or selling 16s should be
profitable just by using the spread (as long as we can get good queue positions). If we
join the 15bid and get filled we should be able to flip 16s and vice versa.
So when there is two-way flow, experienced market makes usually want to get
involved. Trading in this way will lead to more trades (can be over-traded too) and is
perhaps a more aggressive style so to begin with you probably want to stick with all
of the value tools for your trades. Over time though you can think about introducing
more of these trades.
As discussed previously, pace of market is also linked to two-way flow. The more
trades your market achieves the more there are for us to trade in and out of. If the
pace of trades drops, it may be harder to get in and out of trades quickly. So get to
know what a good pace (number of traders) is for your market.
Trade Checklist, Mechanics and Adjustments
Most traders only know if a trade is good, bad or average some time after they are in
the trade. For scalpers, we can usually know this as soon as we are filled. This can
give us a huge advantage but only if we react straight away (discipline).
As soon as we are filled we can go through the following checklist:
•Was it right to be buying (selling)? i.e. was our value and correlations pointing to
buying (selling)?
•Had value clearly been established at the higher price (for longs) or lower price
(for shorts)? i.e. if you are buying 15s did you see decent sized trades at 16 before?
•Did I get a quick fill?

•Did I get a profit or scratch set-up?

•Was I filled by a smaller trader (or ebb and flow of business) or was I filled by a
big trader? This can be linked to the previous point in that if you were filled by a
larger trader you probably won’t get the profit or scratch setup.
If the answers to all of these are ‘yes’ then you have a good trade and the exit should
be quick.
If some answers are ‘yes’ and some are ‘no’, then the trade is an average one. We
should be looking to scratch if not exited straight away.
If most or all are ‘no’ answers then exit straight away and take whatever loss is there.
So, again, we can answer these questions as soon as we are filled on the entry trade
and we should react accordingly.
In addition, these questions and the answers to them will also tell us how to adjust
and improve our trades. Granted, some of the items are out of our control; for
example were we filled by a large or small trader? We cannot change this.
But let’s go through each item and see how it can be changed (if possible)
•Was it right to be buying (selling)? This is mainly based on our correlations. If we
get this wrong either we are not following or understanding the correlation properly
or the correlation has changed. The former requires more learning. The latter means
we should be careful with subsequent trades and perhaps be wary of this correlation
for now.
•Had value clearly been established at the higher price (for longs) or lower price
(for shorts)? If the answer to this question is ‘no’ then you have made an aggressive
trade (perhaps based only on correlation) and you should eliminate these now.
•Did I get a quick fill? If the answer to this is ‘no’ or even ‘not sure’ then you need
to shorten the length of time your orders are in the market and/or queue position
(these two are linked). Often, if the answers to the other questions are ‘yes’ but you
can’t work out what was wrong with the trade, it is speed of fill/queue position.
•Did I get a profit or scratch set-up? If the answer here is ‘no’ there can be 2 main
reasons. First, if we were hit by a large trader. If other things are still positive, the
market should come back to a profit or scratch very quickly. If this doesn’t happen
then look to exit immediately. To avoid this again, we might look to pull orders more
quickly or place our order further away. The second reason we don’t get this set-up is
that our order was too close. So again, here the answer would be to move our order
further away.
•Was I filled by a smaller trader (or ebb and flow) or was I filled by a big
trader? As discussed, this is to some degree out of our hands but reducing the time
our order is in the market can help.
So, there are a number of reasons why a trade can be good, bad or average and a
number of factors we can adjust. In effect, here I have explained to you the
mechanics of a trade; all of its various moving parts.
For most retail traders the only adjustment they make if they lose on a trade is to
change the entry price; if they buy 15s and they lose then they say 15s wasn’t a good
price to buy and they just change that.
In reality there are more inputs into a trade. We can adjust the speed of fill, queue
position, order placement and use of correlation etc etc. In fact, price levels as most
traders use them are of almost no importance to me. I only care about them in relation
to buying below value and sell above value. As long as the price fulfills that criteria,
it is OK for me. I don’t care about support or other so called ‘important’ levels; why
limit your trading to a few points which are bulls*t anyway. I treat each price as a
potential trade opportunity. Remember, frequency, it is powerful and valuable.
So by understanding the mechanics of a trade we can know as soon as we are filled
how we need to react and we can learn after each trade any adjustments that need to
be made. This way we can re-evaluate and improve our trading as the session goes
on. Remember that each day is different; yesterday being filled after 10 seconds
might have been fine but today you note the trade didn’t work out well and you may
have to adjust that downward. As explained previously, we even make these
adjustments intra-day.
I tell clients, that after any loss or scratch it is essential to go through this checklist
and work out what was wrong with the trade. Particularly after a loss, you shouldn’t
continue trading until or unless you have worked out what the problem was.
Otherwise you are doomed to repeat the same mistakes which is something we must
try to avoid.
Scaling Up Size
Every trader should start trading 1 lots but once you regularly achieve the sort of high
win rates we are aiming for obviously we want to increase our size to make more
money. First point to make here is only increase your size if you are hitting a win rate
of around 70% and above. If you increase your size with a lower win rate your P+L
can become too erratic.
It is essential to understand that as scalpers we need to be nimble traders. We are not
looking to become ‘players’ in the market; we just want to easily get in and out of the
order flow. So we don’t want to become large traders and we don’t want to trade a
size that might be difficult to get out of.
If your contract is a thin one such as Dax or Gold where routinely the bids/offers are
less than 20 or 30, I suggest not trading more than 2 lots.
If your contract offers you the chance to trade more (e.g. bids/offers of over 100) you
can certainly get to 5 lots and potentially 10 lots. Personally I wouldn’t advise more
but I do have clients who trade bigger size. Again, keep your trading size proportional
to the average liquidity of your contract. You will need to adjust this and reassess it
on a daily basis (and perhaps even intra day if liquidity drops over lunch for
example).
By increasing our trading size we bring in the problem of getting partial fills. If you
trade say, 5 lots you may get initially filled in 1,2,3,4 or 5 lots. This poses a problem
in relation to quick exits when your DOM is set up for 5 lots. Some DOMs enable us
to have 5 or so quick options to change our size; this is one alternative. Usually
though, it is best to automate the exit by using an order that immediately offers/bids
the amount you have traded at your target price (for instance 1 tick above/below).
One more important point, in keeping with our practice of wanting only quick fills, if
you receive a partial fill you should cancel the remainder. So if I place an order to
buy 5 and get hit in 2 lots, I will cancel the other 3; I want the quickest ones only.
What we are trying to eliminate are the trades where the first 2 make money and the
next 3 lots lose or scratch because they were slower fills.
Challenges of Extreme Volatility
Our goal should be to enjoy a long sustainable trading career. However, if we achieve
that we will undoubtedly have to navigate through times of high and even extreme
volatility. A key theme behind the ideas that I present in this manual is to understand
the specifics behind every part of your trading. Only by understanding every small
point can we really improve our trading. For example, the way I explain to
deconstruct a trade into the various factors that may have contributed to its
performance to find out which specific part needs to be changed.
So what specifically are the challenges we face during times of very high volatility
and how can we adapt?
A higher than normal level of volatility is usually good for an experienced market
making style scalper. Bigger ranges, small traders getting hurt all present good
opportunities. However, extreme high volatility is a different thing altogether. I’ll say
at the start here, that for most traders it is best to stay out. But understanding why we
should stay out and the specific issues at work should still help your learning curve as
a trader.
Harder to Judge Value
There are three main forms of information to help us judge ‘value’; the price action of
our own contract; correlation; and liquidity of our contract which helps us judge
queue position or order placement. In times of extreme volatility, each of these is
impacted.
Price Action of our Contract
During times of extreme volatility, more orders become ‘market’ orders. This is
because traders are worried that if they leave their order as a limit order it won’t get
filled and the market will move massively against them. To coin an old floor
expression (excuse the language) ‘Don’t be a dick for a tick’.
With a higher percentage of market orders coming in, it can be much harder to
recognize which are the true limit orders that determine value. People selling at
‘market’ don’t care where they buy or sell so the prices they create do not really help
us determine value. In usual times, there aren’t many of them and typically we want
to be on the other side of them. As we shall see, in more volatile times even being on
the other side to them isn’t as straight forward as before.
So in times of extreme volatility, the market will print different prices constantly and
it is really hard for us to determine where value is. We shouldn’t use ‘market’ orders
as a reference for value but there are so many of them as to make our decision
making more difficult.
Correlation
One thing that continually catches even big traders by surprise is how correlations
change during times of extreme volatility. I don’t know why it still catches people out
because it Is not a new problem. There are many days during such times when
correlations across multiple assets move towards 1.0 meaning they correlate the
same. These tend to be on days where there are liquidations perhaps due to margin
calls and other losses.
We use correlations to help us judge which side of the spread to trade from and
sometimes as a guide which way value will move. Particularly for those who are
inexperienced, the changing correlations can be a problem. You have to reassess these
more often than usual but the changes themselves can be more dramatic than usual.
However, more experienced traders may not find this as much as a problem. For
example, on the days where clearly everything is being sold/liquidated it can actually
be relatively straight forward to use correlations. Using correlations is actually
always something that is helped by experience. I find that new traders often struggle
to adjust to changing correlations; they try to use the same correlation over and again
in an effort to simplify their process.
Liquidity
In times of very high volatility, liquidity can drop substantially however volumes can
remain quite high. If we add to this scenario the fact there are more ‘market’ orders it
makes our job of judging queue position or order placement much more difficult.
‘Market’ orders hitting into thin liquidity is a recipe for large moves. Judging how
large can be very difficult.
If the extreme volatility persists then margins will be increased too. This will further
reduce trading sizes therefore impacting on liquidity. In addition, it is more likely that
the small retail traders that we want to trade against, are the ones driven out of the
market either because of losses or being unable to fund the higher margins or both.
This will leave the markets with a higher percentage of professional or larger traders
even if these too will have reduced their size.
The thin liquidity and resulting larger moves can provide some great opportunities
but only for those who are willing to take the risks associated.
Gaps
With the reduced liquidity we also see gaps in the order book (prices with no bids or
offers). Many traders will look at these gaps with fear. Those using ‘market’ orders
will get filled at some awful prices. So there are opportunities for us however, again
you have to judge whether you are willing to accept the potential risks. I’ll explain
the basic rules about trading when there are gaps however a big part of our decision
making still revolves around judging liquidity.
First, as with every trade, we have to judge which side of the spread we want to trade
from; do we want to buy or sell? That will require some knowledge of correlation
which, as I have said, some traders may be struggling with. If though, you are
comfortable that you understand the correlations you can think about instigating a
trade.
With gaps you may get a scenario such as below, let’s assume a market where we
want to short (based on our other value criteria such as correlation)

In this example the last trading price is 25. We can see there are no offers between 29
and 35 with11 lots offered at 36 and then another gap to 46.
The first rule about trading in times of higher volatility and particularly where there
are gaps is that we should never be trading for 1 or 2 ticks, we want to be making
more; basically never trade around the spread itself. So above, if I wanted to sell I
would not even consider selling at say 27 or 28/9.
The next and also important rule from a market making perspective about trading
where there are gaps is to never place an order where there are gaps behind. In this
example we should never place a sell order at 30. The reason is that you have no
protection behind you.
You want to place your order where there are people behind you who will protect you
to some degree from a medium sized ‘market’ order.
The next consideration is to ask yourself, ‘if a ‘market’ order came in for a medium
sized trade amount, where would we trade?’ This question therefore still requires a
knowledge of current liquidity and average order size.
Let’s say in this market we consider 10 lots to be a medium sized order. So ask
yourself, ‘if someone bought 10 lots at ‘market’ where would we trade and is there an
opportunity for me to sell?’
The above example has the added problem of the 11 lots on its own being offered at
36. Again with gaps either side, we should not place an order either at 35 or 37. As
there is nothing behind the 11 lot, if it got pulled we have no protection. In volatile
times, the larger orders often do get pulled so this becomes a consideration.
If we think the 11 lot has a chance of being pulled (signs to watch for are it being
pulled if/when the market gets closer to it) then there is a chance that a 10 lot buy
order could see the market trade up to 46.
In my experience it is actually quite common for the larger orders to pull which is
why I have developed this way of trading. In fact, in volatile times lots of orders get
pulled/added constantly which is why ‘market’ orders can trade at such random
prices.
So back to the example above. Off the screenshot, above the 2 lot offer at 46 are
further offers which would provide some protection. Therefore in this example, I
would place a sell order (IF indeed I wanted to sell) at 45. It doesn’t matter to me that
this is so far from the last price; it has a very real possibility of trading and I have the
chance to sell 16 to 20 ticks above the previous trading prices. I would see this as my
potential profit.
As always, this is a judgment call based on your analysis of liquidity and average
market size. If you get that wrong then of course, your order may be too close.
As a rule, in volatile times, if in doubt, it is better to place your order too far away
(and not trade) rather than too close and get a potentially bad trade.
Don’t be scared to place your order really far away if there are lots of gaps. I have in
these times, placed orders (and been filled) over 30 ticks from the previous price.
So at these times, my orders are very defensive. The only trades that I am looking for
are mistakes or the tail end of a ‘market’ order that is some way away from the
previous trade or value.
If the 11 lots is real, then we probably won’t get filled but that doesn’t hurt. The rules
about not placing orders either side of that 11 lot remain though.
We don’t get many of these trades but when we do we have a good chance of making
money. In the above example, if I was filled at 45 and the current bid was still around
26, I have up to 19 ticks of potential profit. Upon being filled at 45 I would in fact
immediately become the best bid, assuming right now that would be 27. If the current
best bid had jumped higher then I would still become best bid in front of that in order
to get filled as quickly as possible. Hopefully I have still set up a trade with a good
risk/reward. I would stop myself out at around 49/50.
If indeed we have picked off the tail end of a ‘market’ order we should expect this
type of trade to make money with a good enough probability. If after you are filled, it
looks like value has actually jumped then you should exit immediately at the best
price you can.
As I say, some people are not comfortable in this situation in which case they should
stay away.
Personally, while judging the value of my contract can be tricky, if I have a good
grasp of the correlation that day then I will look to trade whenever the correlation
makes a decent move. But my orders are also defensive as per above; just trying to
pick off a badly placed order (slippage).
Finally, on this area, I should add that we still want to be filled quickly. Leaving
orders in the market for too long is even more risky on these days.
Hitting Bids/Lifting Offers
A major part of trading like a market maker is to almost always only buy on the bid
and sell on the offer. I have explained the math on that – it is clear cut. However,
sometimes on very volatile days we simply won’t get filled if we wait on the bid or
offer. So, those who trade on these days typically will hit bids or lift offers more than
usual. Personally, again I use correlation as a key factor in my trades but I understand
that these trades are very aggressive and if they fail, I know that I am trading
differently from usual and can stop trading.
The reason why we can try to instigate trades on the wrong side of the spread is
because on volatile days, the potential reward can be greater than usual. I’m giving
away a tick but with a possible reward of perhaps 5 or more.
However, only do this if the spread is 1 or 2 ticks maximum; don’t hit bids or lift
offers if the spread is wide.
Bid: Offer Ratio
In volatile times be even more careful about assuming bids and offers are real or firm;
they are in fact always much more likely to get pulled. The example above is my way
of trying to take advantage of orders being pulled and market orders being filled with
worse slippage than the trader had imagined.
In the screenshot example above, the order book looks more stacked to the bid side
but personally I don’t take to much notice of this during very volatile times. If you
have a good grasp of your correlation and the way your market is moving then back
what you see. Orders get pulled and the order book can turn around quickly. I
remember trading Crude Oil futures during the last oil price crash. There were many
times when the bids heavily outweighed the offers yet the contract kept falling
sharply.
Summary
Trading on these highly volatile days is not for the faint hearted or the inexperienced.
The key inputs of value are harder for us to discern and I think for most traders the
right decision is not to trade.
However, I have written this section in the spirit of explaining exactly what the
problems are with these types of markets. By understanding them more precisely than
just ‘they are volatile’ we can start to construct a way to trade if we want to. But we
are also continuing to learn about trading particularly from the perspective of a
market making style. So even if you don’t choose to trade these types of conditions
you should still learn something from this chapter.
Remember that at all times our number one goal is to preserve our capital so don’t
even try this unless you have practiced first and have already built up a good track
record of scalping.
Judging liquidity and order placement can be difficult and can vary dramatically intra
day. Orders often come in spurts rather than a steady flow. As always we want to only
trade when we believe we can get in and out of a trade quickly. So we must still avoid
one way markets.
These are among the most difficult of conditions to trade. Even I take great caution
when doing so and tend to dramatically reduce my trade numbers. I expect my profit
per trade to be much higher than usual; if it isn’t then I need to reassess either my
order placement or whether to trade at all (in the Pearls of Wisdom section I discuss
the trade stats from a new scalper during some volatile conditions including why the
trades that he believes are good are actually nothing of the sort).
Compared to Other Styles
Most other day traders either use some form of traditional technical analysis or else
more modern versions such as market profile, volume profile, absorption/distribution
analysis etc. I classify all these styles as technical analysis because they all analyze
past data and they are all to some degree or other use some form of ‘level’s.
However, for those of us who actually watch how the market is trading particularly
on these days of high volatility, the idea of using any levels should be one we
eliminate quickly. Why? Because lots of ‘market’ orders hitting into thin liquidity
creates a huge amount of randomness. Sure, ‘levels’ will be created; lows and highs
etc but they will more usually be created out of the randomness rather than the market
finding support or resistance.
These highly volatile days are usually so volatile for a reason – macro events etc. So
markets jump and fall minute by minute in response to news, rumors etc. Again these
will create highs, lows and other ‘levels’ but don’t expect them to hold next time
around when the news flow has changed.
Technical analysis is in fact, a study of trends. High volatility is the complete
opposite of a trend so using technical analysis tools in these times is frankly absurd.
The methods that I have explained in this section are the only ways I have learned to
day trade in these conditions. They are more defensive than usual, with order being
placed further away and less often. Knowledge of liquidity and correlation is still
important though; never trade on one piece of information alone.
What To Look For In Your Stats
As you practice (and you should practice lots before you go live) and as you trade
live there are a number of things to look for in your stats. As I have already said,
make sure you analyse and re-evaluate your trading at least every day, preferably
intra-day. Make lots of notes,, journaling is a good skill and Jigsaw Trading has an
excellent product for this.

Things to look for:

•More scratch trades than losses

•High percentage win rate – 70% and above

•Profit + scratch rate of towards 90%

Losses are typically small. Losses of 3+ ticks should be infrequent and not the norm.
If you have frequent 3+ tick losses then the most likely problems can be orders are
being placed too close and/or you are misinterpreting the information or not
understanding the current day/correlation
Time per trade is low. Generally, the longer you are in a trade, the less likely that it is
a good trade. The best scalps are in and out very quickly. So look at your average
time per trade and almost always, the higher it is the worse your P+L. Reduce it by
getting out of average and poor trades quicker
Particularly, for faster markets, if your loss number is higher than you want, you are
probably not pulling enough orders. As a rule of thumb, the faster the market you
trade, the more orders you will pull. If you don’t pull orders that should be pulled
(usually because they weren’t filled quickly enough) then you will have more losing
trades. In slower markets we have to leave orders in longer so tend to pull fewer
orders.
Always check the performance of long trades and short trades – this should be
reassessed constantly. If, for example, long trades are working well but short trades
struggle then be more careful with short trades (perhaps pull the orders more quickly,
exit quicker etc).
Monitor your performance in all market conditions. Are you better on quiet days or
on busy, volatile days? Once you understand your strengths and weaknesses you
should trade hard on the days where you do well and sit out days where the action Is
not best for you. All the while working (in practice mode) on your weaknesses to try
and up skill. You want your P+L to be good days and days where you don’t trade
rather than good days and bad days.
You should make more trades on your better days than on your not so good days. It
can be common for traders to do say 30 trades on a day where their overall P+L is say
$80 but do 10 trades when their P+L is $300. They have over-traded the day when
they weren’t trading that well. As scalpers, we know that we will trade a lot however,
we don’t want to generate high commissions on days when we are not trading well.
Our highest commission days should also usually be our best P+L days.
Your P+L should be steady, keeping losing days to small numbers (I usually suggest
to around 10 ticks max or around $150). Your P+L should not be a roller coaster.
Some days will be small wins (perhaps $100) others will be bigger. But scalpers look
for steady P+L. As an aside to this, if your P+L is steady and you are an active scalper
you should be able to negotiate better fees with your broker. Your account profile is
exactly what they want.
Look to make gradual improvements in each of these metrics remembering that each
small improvement is magnified by compounding over time.
Summary
This course book has outlined the principles of scalping futures in a market making
style. To perfect this technique you will need to grasp each of the many ideas
presented. I don’t say that is an easy task but if you are prepared to put the effort in
and work on each area, methodically piece by piece then over time you should see the
results come together.
There isn’t one thing in this manual that on its own will be a ‘Eureka’ moment for
your trading but I am sure there are lots of ideas that you wouldn’t have thought of
previously. Remember even small things can be of more significance because we
trade so heavily. Every small change you can make will therefore be of great
importance.
Something like, using the spread might seem small to a new trader but it is worth
probably tens of thousands of dollars to a skilled trader. Understanding liquidity, two-
way flow, pace of market etc is also very valuable to a skilled trader. Even scratching
trades is valuable; if that was the only thing you took from this manual it would still
pay for itself in a few months if you are an active intra-day trader.
As always with trading, discipline will be the key; without it no-one can become a
sustainable profitable trader.
In my opinion the most important thing for a scalper is to be in the ‘now’ – trade the
moment. It doesn’t matter if someone bought 16s an hour ago; if we buy 15s now we
need to know that others are buying 16s now. Essentially what we ask ourselves is
‘what is this contract valued at right now and can I either buy it cheaper or sell it
higher to scalp a profit?’ Don’t be surprised if many times we can’t fully answer that
question. If that is the case we don’t trade. Not trading is always a good option and is
definitely the best option when we are unsure.
It is easy to over-trade so to begin with concentrate on percentage win rates rather
than numbers of trades. If you have a high percentage win rate you can scale up even
if you can’t find too many trades. However we never want to be big traders so make
sure your trading size allows you to nimbly get in and out of the order flow.
Make sure your bad days are only small losses. Pros try to avoid losing days by
sitting out days when they don’t like the market action. Sitting out is a sign of good
discipline. When things are going well, trade as hard as you can; when they aren’t
going so well stop quickly.
Think carefully about which contract you want to trade. Liquidity isn’t a huge issue
for us because we are small traders who value frequency more than size.
Constantly re-evaluate your trading both intra-day and at the end of each day. After a
loss in particular, you should not trade again until you work out the likely problem
with that trade so you can adjust accordingly. Sometimes, there is just bad luck that
something unexpected happened that we could not have known. But this should be
the exception not the norm. If ‘unexpected’ things keep happening to you then you
are likely missing some information.
I have provided you with the checklist to go through regarding the mechanics of a
trade and what could have gone wrong together with how to adjust. It should be a key
reference source for you.
Pre-market preparation is vitally important. Before you trade you should review all
your watch-lists and prepare for the day ahead. Start to think about whether it will be
a volatile or quiet day; how are correlations; any news or data today etc. One point
here is that you shouldn’t be trading over data; wait until after it is out and the market
has steadied and you understand the new market situation.
Pre-market preparation is like a warm up for athletes. If you don’t do it correctly you
will get hurt when you start trading.
To begin with at least, trade the same market at the same time of day. The ES for
example, trades completely differently after hours than it does during the US session.
But even during the US session it is faster on the open and quieter at lunch. Become a
specialist in a contract at a certain time of day before venturing to other times.
This manual contains the principles behind scalping in a market making way however
that doesn’t mean you will all end up trading in the same way or in the way that I do.
I am not trying to create clones (or turtles). Some of my most successful clients have
developed their own methods but based on the principles outlined here. For example,
some hold trades slightly longer than I do; some prefer fade trades; some prefer to
only trade the chop. When I work with traders one-on-one I am happy to work with
their own preference and help them develop their own style. So be prepared to find
your own way but using these principles as a base at least.
Now it’s time for you to work hard!
I wish you all the best
Gary