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Friday September 05, 2008 |
Rounding
Top
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.
The Rounding Top For International Business Machines
In a world of earnings warnings and unfulfilled promises in the winter of
2001, International Business Machines (IBM) was a refreshing success
story. Not only had the firm succeeded where others had failed but by all
accounts, it was building market share and becoming the undisputed leader of the
new economy. One year after introducing is very successful line of Shark
data storage servers they began rolling out software applications for mission
critical UNIX and LINUX platforms. The stock moved from a low of $87.50 on
March 21 to a high of $99.89 on April 16 before releasing first quarter earnings
on April 18. The earnings were in-line with Wall Street expectations. The
revenue numbers were well ahead and the stock spiked higher, trading to $115.87
the next session and as high as $118.93 by May 2. Wall Street analysts
were falling over one another to recommend the stock, IBM was seen as the savior
for the market. But just two days after all of the positive talk the stock
settled back to $111.18. Just two days later the stock was moving higher
again on a note from UBS Warburg suggesting that IBM would "leapfrog"
the competition with its UNIX servers. Once again the stock traded back to
$118.93 only to decline back to $111 by May 14. Once again Wall Street firms defended the stock and IBM pushed to a new high on May 21 at $119.88
following news releases for several new products and contract wins. The next day
IBM CEO Lou Gerstner filed to sell 250,000 shares and the stock began to move
lower again, testing $111 by June 1. The next session IBM announced a
software and hardware deal with the Chinese government. The stock rallied
to back to $118.93 over the next two sessions but by June 26 shares were back at
$111. The final rally came June 29 when IBM announced it had built the
"worlds fastest transitory". After an initial move to $116.87 IBM
shares once again slumped to $111. On July 6 IBM competitor EMC Corp.
(EMC) announced its third earnings warning in as many quarters and IBM shares
gapped though support at $111 at the open. A downside breakout became effective,
IBM shares traded to $92 just two months later.
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.
It makes sense that if
we have a rounding top, we can have a rounding bottom. Let's
examine that chart pattern.
diamond
rounding
bottom
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