Technically speaking, a rounding top is a rally to a new high on strong volume, several weeks of light trade with limited upside progress, several more weeks of light trade with a decided downward bias, followed by a sharp move lower on strong volume.
Why Does It Happen?
At first and maybe even second glance, rounding top patterns are going to look very familiar. This is because they have many of the same characteristics of head and shoulders top patterns. Often there will be a very clear "head", that is a rally to a new high in the middle of the pattern. Rounding top patterns differ from garden variety head and shoulders top patterns in that very often there are multiple "shoulders". So, why does this happen? As you might expect, rounding top patterns occur for many of the same reasons as do head and shoulders top patterns. The first part of the pattern will always take shape after an extended rally to new highs. The flow of fundamental news is usually positive and buyers seem willing to pay increasingly higher prices — for a while. Following one positive development the stock rallies to a fresh new high on strong volume but to the surprise of bullish investors, sellers are more than willing to liquidate positions. After a few sessions, the stock begins to move lower on increased volume. Investors and analysts will normally rationalize this development as simple profit taking but the rise in volume and weak price action is a clue, longer-term investors that bought at lower prices are selling, they are using good news to distribute stock. The rally to new highs and pullback to a nearby support level (reaction low) completes the first phase of the pattern. Because the fundamental news remains positive, bullish investors soon return, sending the stock back to test the recent high but once again they are turned back by sellers and the stock drifts back to the reaction low (now key support). Roused by more positive commentary by either the company or Wall Street analysts buyers make another run at what has become overhead resistance and to their delight, the stock pushes to a new high. There is just one problem, volume is even more feeble than the previous two rallies and the move higher stalls. Buyers are beginning to grow anxious because the fundamental news is positive and sentiment excellent yet sellers continue to exert downside price pressure. A new decline begins but the weakness ends as the stock approaches key support. Against the backdrop of more good news on the fundamental front, buyers make two further attempts to push the stock through resistance. During each attempt volume slows progressively and ultimately the stock slumps back to support. At this point buyers have reached their limit, they begin to question everything — yes, the fundamental data is currently strong but will that last? Five rallies have failed. It is at this point of weakness that the first piece of bad news is released. Suddenly all of the assumptions that lead the stock to new highs are called into question, those that had been supporting the stock panic and key support fails miserably. The stock gaps lower and a huge decline begins. Weeks later the stock trades back to longer-term support.
How are Technical Measures and Targets Derived?
Unlike head and shoulders top patterns, rounding tops 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.
Vital Signs- Symmetry is Important. The most reliable rounding top 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 rally in formation of the pattern. The weak volume and rising price is a good indication that distribution is at work.
- Downside breakouts often lead to small 2-3% declines followed by an immediate test of the breakout level. If the stock closes above this level (now resistance) for any reason the pattern becomes invalid.
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