Rectangle (Neutral Continuation or Reversal)
Introduction | Formation | Other Aspects | Setting Up The Trade & Target | Examples |
The Rectangle is a neutral pattern; it can show up as a continuation pattern or as a reversal pattern. Rectangles are seen during uptrends and downtrends and are often referred to as trading ranges or congestion areas. They share a few qualities with symmetrical triangles.
The rectangle usually takes between 1 and 3 months to develop - occasionally much longer - and is characterized by a pair of parallel horizontal trendlines within which price oscillates until a breakout occurs. While short-term traders often use the well-defined support and resistance levels - of the lower and upper rectangle lines, respectively - as opportunities to enter trades on the minor trend, the longer-term trader cannot really be certain as to the direction of future trend until completion of the rectangle.
A decisive close above the upper rectangle line (resistance line) or below the lower rectangle line (support line) completes the rectangle and points the direction of expected future trend (regardless of preceding trend).
Rectangles as Continuations
Rectangles usually show up as continuation patterns and the initial assumption when spotting a developing rectangle is that the prevailing trend is taking a breather and that the pattern will eventually resolve in the direction of that trend.
A bullish continuation rectangle is depicted in the diagram below. In the lead-up to such a pattern, price has been in an uptrend. Upon entering the phase that will later be called a rectangle, price hits strong horizontal resistance and the trend's progress is stymied.
However, even though buying pressure seems to have dropped off, sellers are not able to gather enough strength to push prices below a newly formed horizontal support level, which is typically several percentage points below resistance. This tug of war between the upper rectangle line (resistance line) and the lower rectangle line (support line) continues - typically for several weeks - until one of them gives way.
In the bullish continuation variant price breaks out above the upper rectangle line (resistance line) to complete the rectangle. Until this point, the trader would have been uncertain about likely future trend, although the seasoned technician pays close attention to the trend volume, in order to try and discern clues. (More about this in the section on Volume below).
Often, there is quick U-turn in prices, back towards the broken upper rectangle line. If the broken resistance level then provides support, a successful "retest" is said to have taken place. While the "retest" or "return move" brings about a bit of nervousness to the trader who already holds a long position in the stock, it is a welcome development from the point of view of the trader who was late to the trade, since he/she now has a second chance to get in on the trade.
Rectangles also occur during downtrends. The diagram above is a depiction of a bearish continuation rectangle. In the lead-up to this pattern, price has been experiencing a downtrend. Upon entering the pattern that is later to be seen as a bearish rectangle, the decline halts for a few weeks/months as the bears take a breather.
For the next few weeks, price oscillates between a resistance line (upper rectangle line) and a support line (lower rectangle line). Here, in the case of the bearish continuation variant, support ultimately fails as price breaks below the lower line and completes the rectangle. The downtrend is then set to resume.
Return moves are common in the case of bearish rectangles and the broken support line now needs to provide resistance to any attempt at moving back into the rectangle, or else the pattern is in danger of failing.
Rectangles as Reversals
As mentioned previously, rectangles can appear as continuations and as reversals.
The diagrams above depict a rectangle that formed at the end of an uptrend (on left) and one that formed at the end of a downtrend (on right).
Duration
Rectangles typically form over a period of 1 to 3 months. However, it is not at all uncommon to find rectangles that span several months (perhaps even a couple of years). As with any other chart formation, the longer that a rectangle has been developing the more significant the future price move.
Volume
Most textbooks suggest paying close attention to the volume that accompanies price swings between the two rectangle lines.
If reaction rallies (moves that start at the lower rectangle line and end at the upper rectangle line) show higher trading activity than do reaction declines (moves from the upper rectangle line to the lower rectangle line), then a bullish breakout and future trend is considered more likely, and vice versa.
Setting Up The Trade & Finding A Profit Objective
Long-term Traders
The long-term trader holds positions in the direction of the preceding rising (declining) trend - in the assumption that that trend will continue upon completion of the rectangle - and places stops on long (short) positions just under (above) the support (resistance) line in order to protect the position in the event that his/her assumptions are proven wrong.
Once the breakout occurs, there is a little more certainty in expected trend.
If the breakout is in the expected direction, then the trade is maintained and stops are raised/lowered accordingly. A price objective is set using the height or vertical distance method. The technician measures the number of price points (or, alternatively, percentage points) between the upper and lower rectangle lines and projects that distance from the breakout point (this process is briefly illustrated in the examples provided below).
If the breakout is not in the expected direction, the trade is stopped.
Short-term Traders
Short-term traders, of course, embrace rectangles because these formations present clearly-defined levels of support and resistance, thus allowing for a "trading of the range", wherein the trader buys at support, sells at resistance and repeats the process until the rectangle is complete.
Examples
Bullish Continuation Rectangle
MT was in an uptrend in Oct '06 - it had rallied from 34 to 43.25 in a few weeks - when it hit resistance and traded sideways between 43.25 and 39.5 for the next 3 months.
Volume subsided over the second half of the pattern when an attempt was made to send price below support at 39.5 in early-Jan, but price bounced off the lower rectangle line once again and moved back into the middle of the pattern. At this point, the trader still wouldn't have been certain as to whether the rectangle was a continuation or a reversal.
Later in the month, price began to rally on higher volume and broke out above the upper rectangle line to complete what was at that point confirmed to have been a bullish continuation rectangle. The target from the pattern was 47; that level was calculated by adding the vertical distance of 3.75 (43.25-39.5) to the level of the bullish breakout (39.5). As you can see, it didn't take very long for the target to be reached.
Bearish Continuation Rectangle
BSX was experiencing a downtrend in mid '05. The stock found support at ~26.85 in late-May. It then rallied to 29.30 found resistance at that level, declined and once again found support at 26.85 through the month of June. Over the next 6-7 weeks price continued to trade within previously mentioned support and resistance.
The pattern would have been designated as a rectangle at this point; the only question was whether it would turn out to be a bearish or a bullish one.
Finally, around 3 months after the start of the pattern, price broke the lower rectangle line together with a spike in volume and confirmed that the pattern was a bearish continuation rectangle. The stock did not continue its descent immediately; a return move was seen on low volume and provided traders with a second chance to enter short positions. The stock then quickly descended to the target of 24.40, which was calculated by subtracting 2.45 pts (29.30-26.85) from the level of the bearish breakout (26.85).
