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Finding The Right Entry Point For A Fundamentally Perfect Trade

Offshore

In many ways, trading is all about reconciling conflicting information and signals. As I regularly point out to anyone that will listen, if there weren’t compelling reasons to do the exact opposite of what you as a trader intend to do with a particular security you would never trade. Every seller needs a buyer and vice versa, and those on the other side of your trade have presumably looked at the same information and arrived at the opposite conclusion. Prioritizing market trends, news and data is therefore an everyday thing for anybody who trades regularly. Sometimes though, the conflict is such that you find yourself split, and that is the case right now with a stock that I have traded successfully in the past, Petrobras (PBR). That conflict has led to inaction on my part, at least for now, but sometimes analyzing inaction can be more informative than looking at an actual trade, and this is one of those times.

PBR is one of those stocks that looks perpetually undervalued, but with good reason. A price/book ratio and price/sales ratio that are both comfortably under 1.0 both indicate that the stock is ridiculously cheap, but also suggest that there is something else you should be looking at. In this case there are two things, a political scandal that has engulfed the company, and what are referred to as “low oil prices”.

The quote marks are because, while oil is undoubtedly significantly below its highs of a few years ago, it is still high on an historical basis even after adjusting for inflation. That often gets overlooked, but for a company like Petrobras that looks decades ahead in their planning, it is significant. They may have stretched themselves a little when crude was over $100, but we are currently a long way from the lows, and remaining here for an extended period is no bad thing.

The political scandal was bad for sure, involving corruption at the highest levels of Brazilian politics and with Petrobras at its center. The worst, however, seems to be over, and it is hard to envisage how any further revelations at this point could be damaging for the company even if they continue to taint politicians’ reputations.

It should be clear by now that, as much of a drag on PBR as those two things have been, neither of them is the cause for my concern now. Indeed, if anything, the continued focus on those after they have ceased to be a major problem is part of the reason I like the stock. No, what is holding me back is something different, and it is something that I often say is given way too much importance by most retail investors, entry point.

(Click to enlarge)

The thing that amazed me most when I moved from a dealing room environment to retail trading is to what extent those on the outside focus on entry points. There is a whole industry devoted to systems that purport to indicate the absolute best level at which to buy. Most desk traders, however, look at things another way, asking themselves “If I buy here, where would I get out?”, and that subtle shift in focus from entries to exits produces a much different mindset. Proximity to logical stop loss levels becomes at least as important as the original reasons for the trade.

In this case, my hesitation about the entry point for a long PBR trade is, in itself, a product of that focus on exits. If, based on the value factors outlined above, I were to buy the stock here, where would I get out? A stop just below the most recent lows of around $9.80 might look logical, but has one obvious flaw… it is too close. PBR is volatile, in part due to correlation with oil and in part because of its own unique circumstances, so a stop loss order around two percent away risks being taken out of the trade before it has a chance to develop.

It would make much more sense to set a stop at around $8.30, just below the August launching point for the recent rally, but that, on the other hand, is too far away. My basic “run your profits, cut your losses” trading style requires that my target for a trade be at least twice as far away as my stop-loss level, so a stop at $8.30 would mean an initial target around $12, a level not seen since October of last year. That may be achievable in the long run, but this is a trade, not an investment and somewhere below $11 is a more realistic target over the next few weeks or months.

What all that means in practical terms is that buying PBR here, as appealing as it is on several fundamental levels, is not a justifiable trade. That is why, while I like the stock, I am holding off. It would make perfect sense to buy at around $9, where the $8.30 stop level and $11 target give the right risk/reward ratio and a rational trade with logical parameters, so I am placing an order there rather than wading in here. If it gets there, great, but if not, so be it.

The lesson here for those new to trading, and maybe even many more experienced traders, is that an idea, no matter how well reasoned, doesn’t become a viable trade until the exit points are right. Sometimes that means missed opportunity, but experience has taught me that that is nothing compared to what can be lost by trading without regard to exits. Even in the frantic, immediate world of trading, patience is sometimes a virtue.




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