NEW YORK (TheStreet) -- One of my favorite chart patterns is called the rounded-bottom breakout. The pattern was introduced to me by candlestick analyst Rick Saddler, who also coined the term "rounded-bottom breakout." Rick also defined the criteria for the breakout. Once you know what to look for, it is very easy to spot and can be entered into any chart software scanner.
In order to find such a pattern in your charts, plot them with the 20-day simple moving average, the 34-day exponential moving average, 50-day simple moving average and the 200-day simple moving average.
Once you have these moving averages on your chart, the breakout is very easy to spot. I also plot the 8-day exponential moving average, or t-line. The t-line isn't needed to spot the breakout, but it is useful in choosing an exit point once you are in a trade.
Here are the criteria for the rounded-bottom breakout:
- The chart needs to be a downtrend, and the longer the downtrend, the better. The 20-day SMA is below the 34-day EMA, which is below the 50-day SMA, which is below the 200-day SMA. This is a clear downtrend.
- There should be a bottom formed, such that the chart is trading sideways, forms a double bottom, and has clearly reached its low. Then you want the price action to come above the 50-day SMA, thereby causing the 20-day SMA, the 34-day EMA, and the 50-day SMA to cross over to be on top of each other from being below each other.
- The actual trigger is when the stock price, the 20-day SMA and the 34-day EMA cross above the 50-day SMA. Usually the price is first to close above the 50-day SMA.
- The breakout occurs when there is confirmation of a trend reversal, a price close above the 50-day simple moving average, and when the 20-day SMA and the 34-day EMA cross over the 50-day SMA.
- Ideally, you want the price action and the 50-day SMA to be at least 10% below the 200-day SMA. The larger the percentage below the 200 SMA, the greater the gain potential. This will occur in a solid downtrend.
- The main target in a rounded-bottom breakout is the 200-day simple moving average, since that is likely the next resistance level. There may be a more compelling target, depending on the individual chart, but in most cases the 200-day SMA is the best target. In a chart that is in a long-term downtrend, you may want to look for a lower target, such as strong resistance levels that occur before the 200-day SMA.
The rounded-bottom breakout is a series of events. First there is a downtrend. Then there is a bottom formed. At the bottom, there is usually consolidation, from a few days to several months and sometimes the chart will form a double/triple bottom, retesting the bottom. During the consolidation phase, the moving averages start to crunch together, then they start to cross over each other, as a new trend is forming.
A good entry point is when the 34-day EMA crosses over the 50-day SMA, but because the moving averages are lagging, this entry point may come too late for the trade. The best entry is based on your own trading techniques and your own trading plan, so know your plan and stick to it. I like to enter when the price closes above the 50-day simple moving average. Then I set a stop just below the 50-day simple moving. However, all the pieces of a chart need to be considered, as these are guidelines and should be adjusted depending on your own risk tolerance.
For TC2000 users, here is the input for the scan, so you can watch for it yourself: ABS(C - AVGC200) / C > .10 AND C < AVGC200 AND C > AVGC50
For Think or Swim users, here is the scan to put into the ThinkScript editor: SimpleMovingAvg() is less than MovAvgExponential("length" = 34) and MovAvgExponential("length" = 34) is less than SimpleMovingAvg("length" = 50) and SimpleMovingAvg("length" = 50) is less than SimpleMovingAvg("length" = 200) and close is greater than SimpleMovingAvg("length" = 50)scan
As with all chart patterns and signals, there needs to be confirmation of a trend reversal, and the rounded- bottom breakout is no different. Confirmation comes when there are several days of trading above the 50-day simple moving average, and the uptrend is established.
Here is the perfect example of the rounded-bottom breakout's potential. The Company is Halcon Resources (HK).
At the time of publication, Burt had no positions in stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.