Stock Trading Strategies > Technical Analysis > Chart Patterns

Rounding Bottom

Technically speaking, a rounding bottom is a decline to a new low on strong volume, several weeks of light trade with limited downward progress, several more weeks of light trade with a decided upward bias, followed by a sharp move higher on strong volume.

Why Does It Happen?

Like the rounding top pattern, the rounding bottom is often mistaken for its head and shoulders counterpart. This is because the rounding bottom has a lot of the same parts. Both the rounding bottom and head and shoulders bottom have a series of peaks and valleys and declining volume throughout the pattern. Of course the difference is that the rounding bottom has what appears to be multiple "shoulders". So, why does this happen? Like the rounding top, rounding bottom patterns are almost deceptively simple in nature.

They are all about the orderly transfer of shares from anxious sellers to serious, value minded longer-term investors. Through a series of peaks and valleys sellers are slowly (almost painfully so) removed. The first part of the pattern will always take shape after an extended decline to new lows. Against the backdrop of very negative fundamental news, sellers become anxious and willing to sell their shares for progressively lower prices. At some point a particularly negative news development such as an earnings warning, product delay or key executive departure hits the news wires and the stock slumps to a new low on huge volume. One by one Wall Street analysts rush to cut estimates and make disparaging comments and the free fall in price continues. But to the surprise of many, the selling is severe but oddly brief. The reason for the stock strength is that longer-term investors are beginning to accumulate large positions for the longer-term. Days later the stock moves higher on good volume.

This brief rally in price affords a new selling opportunity for those that did not exit ahead of the first major decline and the price action reverses creating a small resistance level (reaction high). Once again the stock moves lower, testing the most recent new low before buyers mysteriously step-in and support the stock. A rallies ensues and a move back to the reaction high, now key resistance occurs. Normally this type of impressive price action would be enough to make sellers re-think their strategy but the fundamental news is terrible and just days later the stock is rocked by another negative development. This time the stock moves to a fresh new low but volume is noticeably less than the previous two declines. After a few sessions meandering at the new lower levels, the stock begins to rebound on better volume on the first piece of good fundamental news in several weeks. The rally lasts for a few sessions but it is stopped dead in its tracks at the short term resistance level. Another decline begins on more bad news but it too is short-lived and a rally back to resistance occurs. This process is repeated one more time before sellers get the idea that perhaps the stock is not going to move significantly lower. Anxiety levels grow for short sellers and longer-term holders that purchased the stock at higher levels begin to feel better about the stock. The idea is that if the stock is not declining amid the current stream of bad news it must be headed higher -- and they are unwittingly correct. In the days ahead more good fundamental news hits the news wires and the stock explodes higher. Weeks later the stock trades back to longer term resistance levels.

How are Technical Measures and Targets Derived?

Unlike head and shoulders bottom patterns, rounding bottoms generally do not lend well to price targets because the pattern is meandering. In most cases one can expect a decline back to the longer-term support level following a break below key support.

Rounding Bottom for Rite Aid

There was a time when Rite Aid (RAD) was among the greatest momentum stocks in the land. Several quarters of strong results coupled with a terrific management team pushed the stock to one new high after another -- until it was revealed that the earnings were an illusion and the management team would have to go. By July 11, 2000 investors had slashed the stock from better than $22 to $8.50. That day a new odyssey began with the legitimate real earnings and full disclosure of just how bad previous reports had really been. That day the company reported a staggering loss of $238 million or 92-cents per share for the quarter and $1.1 billion or $4.45 per share for the year. Wall Street analysts rushed for the exits with earnings revisions and a slew of negative commentary. The stock slumped to $4.13 by July 27 and $3 by September 21. There was a brief rally to $4.13 by November 2 but by the time Rite Aid reported a wider than expected loss on November 10 the stock was once again on the move lower. The stock traded to $2.46 on November 26. Once again the stock rallied to the $4 level two weeks later but weak same store sales and general weakness in the retail sector sent the stock to a fresh new low at $1.81 on December 29. The news got better in the new year with Rite Aid reporting smaller losses and stronger pharmacy sales. Rite Aid shares pushed to $4 on January 12 but sellers quickly returned and a decline back to $3.31 occurred just a week later. Once again, the decline proved short-lived as news of a convertible debt offering sent the stock back the $4 level by February 6. There was more weakness on news that former Rite Aid executives had been named in a fraud suit but buyers proved resilient and the stock began to climb. By March 5 the stock had reached $6.

Vital Signs

Symmetry is important. The most reliable rounding bottom patterns do not stray from the confines of a tight semi-circle and usually resemble head and shoulders top patterns with two left shoulders, one head and two right shoulders. Obviously askew patterns should be avoided.
It is important that volume decline on each successive move lower and begin to increase as the stock moves higher. The weak volume on declines and rising volume on rallies is a good indication that accumulation is at work.
Upside breakouts often lead to small 2-3% rallies followed by an immediate test of the breakout level. If the stock falls below this level (now support) for any reason the pattern becomes invalid.

The final two patterns left to examine are wedge formations. Let's take a look at the rising wedge.

rounding top rising wedge