When traders talk about a “rounded bottom,” don’t let your mind wander away from the trading room. They’re discussing a useful reversal pattern that often uncovers potential trading opportunities.

It’s quite simple: If a stock’s price action is shaped like a saucer, it means the stock could potentially reverse its current trend, and this pattern is seen as having a “high probability” of breaking out to the upside. That said, let’s look at the price action you must see to decide if a stock has a rounded-bottom pattern.

Rounded bottom explained

With the rounded-bottom breakout pattern, you first want to see the stock exhibit downtrending price action, meaning lower highs and lower lows. Next, you’re looking to see the moving averages confirming the downtrend.

Thus, you want to see the 20- and 50-period simple-moving averages (SMA), as well as the 8-period exponential-moving average (EMA), sloping downward.

Thereafter, you want to see price action stall and start to form a bottom.

Following that, the stock should start to rise, with the 8-period exponential moving average crossing — and staying above — the 20-period simple moving average.

Finally, the rounded-bottom breakout should occur, with the price crossing above the 50-period SMA.

At this point, you want to see the moving averages confirm the breakout, meaning that the price is above the 50-period SMA, and the shorter-term moving averages (MA) are above the longer-term MAs.

Here’s an example in the daily chart on Natus Medical Inc. (BABY):

Notice the downtrend, with the moving averages sloped downward initially. Thereafter, the stock formed a bottom and price broke above the MAs. Moreover, the 8-day EMA was above the 20-day SMA, and the 20-day SMA was above the 50-day SMA. Notice that the stock gapped down previously; you could potentially enter this trade for a gap fill.

Final thoughts

Rounded-bottom breakout patterns are widely used for spotting potential trend reversals. Identifying them becomes second nature once you do your homework and memorize the necessary conditions but — similar to nearly all technical patterns — rounded bottoms don’t work out all the time, so be sure to protect yourself by setting appropriate stops.

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   Petra Hess runs PetraPicks.com. She is a technical swing trader and long-term investor in domestic and Canadian stocks and ETFs.

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