Ask Colin

How do I choose the appropriate retracement for placing my stop-loss?

Note: I abbreviate questions posted on the Ask Colin page, so that they can be easily scanned by readers. In this case, it is necessary to mention that the reader who asked the question posed it in terms of seeing a retracement on the daily chart which, if he used it as his stop-loss, his money management rules would have enabled him to take the trade. However, his concern was that when he looked at the weekly chart, the retracement was much lower and the risk to a stop-loss generated by the retracement on the weekly chart precluded him taking the trade.

What you are asking about here is one of the most difficult aspects of technical analysis-based trading for most people. It comes down to the question of time frame. In order to deal with time frame questions, it is essential that we have a clear trading plan that defines the time frame we are trying to trade.

So, a day trader has it easy. She does not carry trades over night. Therefore the trends she trades must be obvious within the day on the intra-day chart. She may have reverence to daily or weekly charts to know where the support or resistance levels are in longer time frames, but she should focus on the intra-day chart.

A short-term trader, who is trying to trade trends that last from say three to ten days, will rely mainly on the daily chart. He will know where the key levels are on the weekly chart, but really, they will also be obvious on his daily chart, so long as his trading screen has a couple of months of data on it, or the price is not making new highs or new lows for the screen. I say this, because the highest high of an upswing on the daily chart will also be the highest high for that swing on the weekly chart. It has to be by definition.

If the short-term trader sees a retracement on the daily chart, that vanishes on the weekly chart, there are only two possibilities:

1. That the swing he is looking at on the daily chart is shorter than it is possible to trade off a weekly chart. In other words, it will typically last less than a week and the weekly chart will not be relevant for placing the stop-loss. It may be for managing the trade though, if there are significant levels on the weekly chart just above his buying price.

2. That the swing he is trying to trade is clear on the weekly chart, and will be on the daily chart if he has enough data on the screen, but he is looking only at a part of it on the daily chart - i.e. the time frame in point 1. above.

So, it really comes down to having a clear idea of the time frame you are trying to trade.

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