The Rectangle Formation
posted under
Philosophy of Technical Analysis
by ceecabolos
The rectangle formation often goes by other names, but is usually easy to spot on a price chart. It represents a pause in the trend during which prices move sideways between two parallel horizontal lines. (See Figures 6.9a-c.)The rectangle is sometimes referred to as a trading range or a congestion area. In Dow Theory parlance, it is referred to as a line. Whatever it is called, it usually represents just a consolidation period in the existing trend, and is usually resolved in the direc.tion of the market trend that preceded its occurrence. In terms of forecasting value, it can be viewed as being similar to the symmetrical triangle but with flat instead of converging trendlines.
A decisive close outside either the upper or lower boundary signals completion of the rectangle and points the direction of the trend. The market analyst must always be on the alert, however, that the rectangular consolidation does not turn into a reversal pattern. In the uptrend shown in Figure 6.9a, for example, notice that the three peaks might initially be viewed as a possible triple top reversal pattern.
The Importance of the Volume Pattern
One important clue to watch for is the volume pattern. Because the price swings in both directions are fairly broad, the analyst should keep a close eye on which moves have the heavier volume. If the rallies are on heavier and the setbacks on lighter volume, then the formation is probably a continuation in the uptrend. If the heavier volume is on the downside, then it can be considered a warning of a possible trend reversal in the works.
Swings Within the Range Can Be Traded
Some chartists trade the swings within such a pattern by buying dips near the bottom and selling rallies near the top of the range. This technique enables the short term trader to take advantage of the well defined price boundaries, and profit from an otherwise trendless market. Because the positions are being taken at the extremes of the range, the risks are relatively small and well defined. If the trading range remains intact, this countertrend trading approach works quite well. When a breakout does occur, the trader not only exits the last losing trade immediately, but can reverse the previous position by initiating a new trade in the direction of the new trend. Oscillators are especially useful in sideways trading markets, but less useful once the breakout has occurred for reasons discussed in Chapter 10.
Other traders assume the rectangle is a continuation pattern and take long positions near the lower end of the price band
in an uptrend, or initiate short positions near the top of the range in downtrends. Others avoid such trendless markets altogether and await a clearcut breakout before committing their funds. Most trend-following systems perform very poorly during these periods of sideways and trendless market action.
Other Similarities and Differences
In terms of duration, the rectangle usually falls into the one to three month category, similar to triangles and wedges. The volume pattern differs from other continuation patterns in the sense that the broad price swings prevent the usual dropoff in activity seen in other such patterns.
The most common measuring technique applied to the rectangle is based on the height of the price range. Measure the height of the trading range, from top to bottom, and then project that vertical distance from the breakout point. This method is similar to the other vertical measuring techniques already mentioned, and is based on the volatility of the market. When we cover the count in point and figure charting, we'll say more on the question of horizontal price measurements.Everything mentioned so far concerning volume on breakouts and the probability of return moves applies here as well. Because the upper and lower boundaries are horizontal and so well defined in the rectangle, support and resistance levels are more clearly evident. This means that, on upside breakouts, the top of the former price band should now provide solid support on any selloffs. After a downside breakout in downtrends, the bottom of the trading range (the previous support area) should now provide a solid ceiling over the market on any rally attempts
A decisive close outside either the upper or lower boundary signals completion of the rectangle and points the direction of the trend. The market analyst must always be on the alert, however, that the rectangular consolidation does not turn into a reversal pattern. In the uptrend shown in Figure 6.9a, for example, notice that the three peaks might initially be viewed as a possible triple top reversal pattern.
The Importance of the Volume Pattern
One important clue to watch for is the volume pattern. Because the price swings in both directions are fairly broad, the analyst should keep a close eye on which moves have the heavier volume. If the rallies are on heavier and the setbacks on lighter volume, then the formation is probably a continuation in the uptrend. If the heavier volume is on the downside, then it can be considered a warning of a possible trend reversal in the works.
Swings Within the Range Can Be Traded
Some chartists trade the swings within such a pattern by buying dips near the bottom and selling rallies near the top of the range. This technique enables the short term trader to take advantage of the well defined price boundaries, and profit from an otherwise trendless market. Because the positions are being taken at the extremes of the range, the risks are relatively small and well defined. If the trading range remains intact, this countertrend trading approach works quite well. When a breakout does occur, the trader not only exits the last losing trade immediately, but can reverse the previous position by initiating a new trade in the direction of the new trend. Oscillators are especially useful in sideways trading markets, but less useful once the breakout has occurred for reasons discussed in Chapter 10.
Other traders assume the rectangle is a continuation pattern and take long positions near the lower end of the price band
in an uptrend, or initiate short positions near the top of the range in downtrends. Others avoid such trendless markets altogether and await a clearcut breakout before committing their funds. Most trend-following systems perform very poorly during these periods of sideways and trendless market action.
Other Similarities and Differences
In terms of duration, the rectangle usually falls into the one to three month category, similar to triangles and wedges. The volume pattern differs from other continuation patterns in the sense that the broad price swings prevent the usual dropoff in activity seen in other such patterns.
The most common measuring technique applied to the rectangle is based on the height of the price range. Measure the height of the trading range, from top to bottom, and then project that vertical distance from the breakout point. This method is similar to the other vertical measuring techniques already mentioned, and is based on the volatility of the market. When we cover the count in point and figure charting, we'll say more on the question of horizontal price measurements.Everything mentioned so far concerning volume on breakouts and the probability of return moves applies here as well. Because the upper and lower boundaries are horizontal and so well defined in the rectangle, support and resistance levels are more clearly evident. This means that, on upside breakouts, the top of the former price band should now provide solid support on any selloffs. After a downside breakout in downtrends, the bottom of the trading range (the previous support area) should now provide a solid ceiling over the market on any rally attempts
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