Successful Scalping.

Day-trading works best in high volume active markets where the swings are wide and easier to read. Learn the principles of price behavior in the S&P 500 so you can capture profits consistently.

SHORT-TERM TRADING requires good market volatility, volume and consistent liquidity.

Ideally, there should be two to three choice "swings" in the market each day, in addition to numerous small scalping opportunities. Index futures are unique in that they are not based on an underlying cash market with commercial interests, as are most commodity futures markets. There also is a wealth of information pertaining to the underlying equity market's technical condition, such as overall breadth and volume readings, as well as many characteristics that don't exist in other markets. We will describe a few of the patterns that can help a trader to enter the S&P 500 market for a very short period of time and capture two to three points on a consistent basis.

The basics Four key components compose consistently successful trading: execution skills, money management, trading methodology and the psychological challenges. Each component is equally responsible for the overall bottom line. Weakness in any area makes profitable day-trading difficult, and of these, solid execution and money management skills are particularly critical.

Because commissions and slippage make up a higher percentage of each trade, execution skills are more important to successful day-trading than position-trading or trend following. Because most trades will be entered slightly early or slightly late, understanding when to use a market order vs. a limit or stop order can improve your trade location while ensuring you get the trade on. Fortunately, practice and experience can improve execution skills greatly. The most important point to understand is that good execution skills can account for over 50% of the bottom line, regardless of the initial trade setup or strategy.

Money management also can improve with experience. Limiting losses and exiting positions that are going nowhere is crucial. But even more essential is identifying the two to three times per month when a really good trade can be pressed, thus capturing much larger than normal profits. Short-term trading allows for more aggressive use of leverage because risk can be controlled on a tighter level. Many day-traders learn to think in terms of time windows instead of price windows. Because the best day-trades tend to work right away, a viable stop concept may be five minutes or 20 minutes, as opposed to a fixed price stop. Knowing when to be more aggressive and use more leverage can be the difference between a good year and an excellent one.

Prep work The most important thing to assess before the day starts is what type of volatility environment is expected. On a daily basis, the market tends to alternate between choppy consolidation days and range expansion or "trend" type days. Different types of day-trading strategies work better on different types of days. A day-trader who likes to buy breakouts quickly will find himself in trouble if he does not understand when a market is due to enter into a protracted consolidation phase.

It is crucial to recognize trend days so as to avoid a novice mistake: taking a countertrend trade on the basis that the market appears short-term overbought or oversold. Although there may only be two to three true trend days a month, most are preceded by distinct conditions that can be identified ahead of time. These conditions include a period of range contraction (identified by a narrowing of the daily average true range), a break of a key chart point such as new highs or lows on the daily charts, or a large opening gap.

If a trend day is expected, one basic guideline to use is that the direction the market trades out of the first hour's range will tend to be the direction of the day. Trend days do not always have to display an initial increase in volatility. In fact, some of the strongest trend days start out as "creeper" markets with a slow "oozing" type of action. Often later in the afternoon, the move starts to become parabolic. Sometimes the best trades are those that participate in the last hour of the day.

Patterns After the market has made a large move, it tends to spend one to two days consolidating and forming a trading range. Trades can be made based on looking at the support and resistance levels that are being formed and then entered on "tests" of those levels. Intraday countertrend indicators work well in a consolidating market. One of the more interesting indicators to use in a trading range environment is the "ticks," the number of New York Stock Exchange stocks on an "uptick" vs. a "downstick." In a normal trading environment, +500 and -500 tend to represent overbought and oversold levels. However, in a trending market, these readings can reach -1300 in a downtrend or +1000 in an uptrend.

Ticks should be watched in conjunction with the "Tiki's" (or "Ticki's" on some data feeds). This reading is the net number of Dow stocks on an uptick or downtick. In general, an overbought/oversold range is +24 to -24. If the Tick reading is +500, but the Tiki only registers a +12, then another upward surge is likely. The implication is that trading programs have not fully kicked in yet. These programs almost always cause the Tiki's to reach +22 to +26.

Ticks also function as a confirmation/non-confirmation indicator. If the market makes a new high, the ticks should make a new high to confirm the upward momentum. When this occurs, retracements can be traded in the direction of the trend. However, if the price makes a new high and the ticks do not, a reversal may be likely. Always remember, in a strongly trending environment, ticks and momentum-based indicators will tend to give false overbought or oversold readings. You must always pre-qualify your trading environment.

Lastly, markets start to show signs of forming a base when several large downtick readings occur over a few days and the price holds near the same level for each of the downtick readings. This is called "the ship isn't sinking" (see "Ticks of the trade," left). In other words, the market is firing its best shots, but the S&P 500 remains afloat. Fear and panic are stronger at market bottoms, so it is more likely that extreme tick readings will register at selling climaxes. When the market tops out, it often does so on complacency and a general drying up of buyers. Often, there is a lack of any uptick readings at tops. This pattern, called "the dog didn't bark," is a non-confirmation setup that can be seen in "Ticks of the trade" (page 12).

Confirmation and non-confirmation patterns also set up between the S&P 500 and other market indexes. Our favorites are the Nasdaq futures and the Dow index. At many important turning points, there is a non-confirmation pattern between the S&P 500 and one other index. When the S&P's make a higher intraday high, but the Dow fails to go to a higher high, it is a sign of a potential downside reversal. In addition, when the S&P's and Treasury bonds are trading in a correlated fashion, there are often intraday turns where the bonds may make a new low but the S&P holds, indicating relative strength. A rally may soon start. All of these ideas are tape-reading tools. Most discretionary professional S&P traders use some form of tape-reading to help time initial entries or exits. One last trick is to monitor the top four or five momentum leaders of the most heavily traded stocks. These may include MSFT, AOL, IBM, and AMZN. The main momentum leaders often have a one- to two-minute lead-time on the S&P.

Other than the above setups, there also are many simple yet elegant trading strategies that can be derived from using classic chart patterns. Remember that most traders need to make decisions in a quick period of time. Raw price is simply the most sensitive and timely indicator and looking at bar charts is the easiest way to take advantage of this. A trader needs to keep in mind that researching too many indicators is a trap. Analysis paralysis can set in and the trader can no longer pull the trigger. If you don't pull the trigger, you won't eat.

Trading off chart formations works best in market environments with good volume. The better the volume and volatility, the "cleaner" the chart formations look. Some of the cleaner patterns to look for are classic small bear or bull flags that form after the market has begun to move out of a trading range (see "Classic form," page 13). Once again, the key to success with this type of strategy is recognizing that the market has ended its consolidation phase and is beginning to trend.

To help train your eye to see char formations or sideways consolidation areas on a bar chart, it is helpful to plot a 14-period Average Directional Index (ADX) beneath the chart. Once the ADX drops below 18, draw trendlines across the support and resistance levels. Most likely there will be a classic chart formation such as a rectangle, triangle, or general extended trading range. Once the market moves out of this trading range, look for the first small pause or consolidation to enter the market. This entry offers the most favorable risk/reward ratio and the trade should start to move in your favor right away.

Conversely, in a strongly trending market where the ADX has riser above 30, any technical correction generally will demand a retest of the most recent swing high or low in the direction of the trend (see "Holy grail sale," page 13). We look for a pull-back to the 20-period exponential moving average on five-, 15-, 30- and 60-minute bar charts. This trade is termed "The Holy Grail" because it is one of the highest probability trades.

Day-trading demands a special fortitude -- a trader needs to be twice as sharp and three times as defensive. Much of a trader's success in day-trading will depend on his ability to recognize environments that offer only marginal trading conditions, and then being able to stand aside. Patience is the key, for much of trading is learning to keep what you make and not to give back your profits in sloppy markets.

Understanding these concepts is critical to building a roadmap for success. It can be easy to make small scalps in the S&P 500 off the one- and five-minute bar charts, but to truly make a great living, price behavior principles must be understood.

Linda Raschke is president of LBRGroup Inc., a commodity trading advisor. She has been a professional trader for over 18 years.