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Should You Try And Grab This Falling Knife?


There is an old traders’ cliché that says that it is dangerous to attempt to catch a falling knife. Like most clichés there is an element of truth to that, but I can assure you that thousands of traders in thousands of dealing rooms around the world do that, or more accurately what looks like that, every day. They know that markets tend to overshoot and that there is good money to be made trading retracements, but they have rules for entry that increase their chances of finding the low and decrease their risk.

The most common of those is to wait until the knife, while it looks to be still falling, is actually bouncing around on the floor. That means waiting until whatever you are trading has shown signs of forming a bottom. With that in mind, take a look at the chart below for Petrobras (PBR).

(Click to enlarge)

I know it looks ugly at first glance but take a closer look at the last few candles. What you see there is a potential bottom forming, setting up the kind of trade I mentioned. The low of this move was reached on June 1st at $9.20, a level that was attempted again six days later, once again without breaking through. The low on that occasion was $9.22 and while that two cents may not seem important there are major implications to even a very slightly higher low on the second try at a level.

When traders see a major support forming it is often based on big commercial or fund orders at the level. Those that are working those orders cannot “front-run” them by buying for themselves just in front of the order level, but those that know they are there because they sold into them on the run down can, and in this case did, raising the low point by just a couple of cents. Of course, there are no guarantees to any trade, but as we approach $9.20 again after a bounce it certainly catches the eye. For those with a short-term outlook, just playing that technical read by buying at around $9.30 (the level as I write) with a stop just below the low, say around $9 and a target of a return to $10 would be a viable trade, but in this case, I prefer more of a swing-trade structure.

Obviously the PBR chart wouldn’t look like it does without some fundamental reason, and there are plenty of those. In fact, you could say that there are too many. The stock has come up against a perfect storm of bad news over the last few weeks. PBR is the Brazilian state oil company and many of its past problems have come from political control. There has been an ongoing corruption scandal, but in the market’s eyes that has been more than offset by the resulting pledge of the government that it would stop interfering in PBR’s pricing and other decisions.

Or at least it was until May 23rd, when that pledge was broken. Oil’s climb led to high diesel prices in Brazil that prompted strikes and disruption by truckers. PBR cut diesel prices in response, and while CEO Pedro Parente insisted at the time that that was not a political decision, analysts stateside felt that it looked, walked and talked too much like a duck to be anything else. Those suspicions were effectively confirmed when Parente resigned a week later.

In addition, oil was coming off its highs at that time and the dollar, after a slow sustained decline, had turned tail and was appreciating, not to mention that the corruption scandal that has dogged PBR for years just refused to go away. All in all, they was being hit with bad news from every side, so the massive drop was easily explained.

At some point, though, there are no more shoes to drop. After such rapid-fire bad news that is likely the case here. If so, then a substantial recovery over the next couple of months is likely. To give room for that to play out though you do not want your stop loss too close to that $9 level. There is always the chance of a false break that would squeeze you out, so a stop-loss at around $8.30 would be preferred. As to a target, I would be initially looking for a break back above $10, but rather than get out there I would use it as an opportunity to move the stop up to a level that represented a profit, then see how high we could go.

There are reasons, both technical and fundamental, to believe that the worst may be over for PBR, so grabbing this particular falling knife on the bounce looks worth the risk.

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