The Rectangle Formation

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The Rectangle Formation

The rectangle is a classic technical analysis pattern that is defined by horizontal lines that indicate considerable support and resistance. It is possible to trade it effectively by buying at support and selling at resistance, or by waiting for a breakout from the pattern and using the measuring concept.

Key Takeaways

  • When the price moves between horizontal support and resistance levels, it forms a rectangle.
  • As the price goes up and down between support and resistance, the pattern shows that there is no trend.
  • When there is a breakout and the price moves out of the rectangle, the rectangle comes to an end.
  • Some traders like to trade rectangles by purchasing around the bottom and selling or shorting towards the top, while others prefer to wait for breakouts.

The Rectangle in Classical Technical Analysis

In technical analysis, the rectangle formation is an example of a “price pattern.” Price patterns are based on the work of Richard Schabaker, widely regarded as the founder of technical analysis, and Edwards and Magee, who produced what many consider to be the bible on the topic.

This era of technical analysis stems from a time when charts were recorded by hand on graph paper and even basic moving averages (SMA) had to be kept by manually or with the use of a massive, bulky adding machine.

In contrast to current technical analysis, which focuses on indicators such as moving average convergence divergence (MACD), technical analysts considered that price patterns repeat themselves over and again. Pattern identification included pattern prediction and, as a result, trading profit.

Many of the pricing patterns are geometrical in nature. Triangles, pennants, and wedges may be ascending, descending, or symmetrical. More fantastical forms, such as the head-and-shoulders configuration, are sometimes seen.

The Rectangle: Supply and Demand in Balance

A pricing chart or graph is analogous to an X-ray of supply and demand. Figure 1 depicts a rectangular pattern in which supply and demand are roughly balanced over a long period of time. The shares move in a confined range, encountering resistance at the top of the rectangle and finding support at the bottom. The rectangle might emerge slowly over time or fast amid a somewhat wide-ranging sequence of limited variations. Schabaker observes that its dimensions are similar to a square.

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In any event, it is a pattern that indicates trader hesitation, with the bulls and bears almost equal in strength.

Figure 1.

The rectangle, most specialists believe, may be used as a reversal or continuation formation. As a reversal pattern, it signals the conclusion of an upward or downward trend. As a continuation pattern, it denotes a halt in the current trend, with the assumption that the former trend would restart later. The rectangle depicts a tug of war between buyers and sellers in either situation. In the end, either accumulation or distribution wins, and the shares breakout or crash.

“Significant” Support and Resistance

Grasp the rectangle formation requires an understanding of the principles of support and resistance.

  • Any price point below the present market price where purchasing should emerge to produce, at least briefly, a halt in a downturn is termed as support.
  • In contrast, resistance is any point above the present market price at which selling should develop to cause, at least momentarily, a halt in an advance.

In a rectangle, what is known as “significant” support or resistance arises – that is, a price level that is returned to repeatedly. While trendlines in technical analysis are often drawn on a diagonal, support and resistance diagrams need horizontal trendlines.

ImClone Systems: an Example of a Rectangle Formation

ImClone Systems (IMCL) Figure 2 uses open-high-low-close bars (rather than candlesticks) and is devoid of any indicators such as MACD. The sole addition is a 30-week moving average (MA), which might have been generated in the past.

Figure 2.

Several observations may be made about this chart. First, notice that an intermediate uptrend line that has been in place for almost a year has been broken. The break indicates that the upswing has come to an end. As a result, the protracted rectangle might be a reversal or a consolidation formation. The pattern’s interpretation is undetermined until there is a breakdown or breakout from the constraints of the rectangle – around $37.50 to $47.50.

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Second, horizontal lines on the chart represent substantial support and resistance. Significant support was developed in September, tested twice early in the year, and retested in June. There was enough buying activity to send the stock higher at each test of support.

Significant resistance at $47.50 was initially encountered in August, and has since been tested in October, April, and July. At each stage, selling outnumbered purchasers, and the stock fell. The rectangular shape is formed by this vacillation between strong support and strong opposition.

One last point to consider is the slope of the 30-week MA. This, more than any other moving average, may best reflect the trend. It connects to the rectangle by demonstrating the formation’s sideways character. The 30-week MA will slope up or down in an uptrend or downturn, not sideways. Take note of how the chart sloped upward at the beginning, mirroring the uptrend. Later, as a result of the extended consolidation, it leveled and started to slope laterally.

Trading the Rectangle

Two fundamental tactics for trading a rectangle are as follows:

  • The first is to purchase at resistance and sell at support (one can also sell short at resistance and cover the short sale at support).To reduce risk, a very tight stop of about 3% might be used if the stock falls down from support. For example, if ImClone was purchased at $37.50, the stop-loss would be 3% less than $37.50, or $1.12. If the stock reached $36.38 ($37.50-$1.12), the trader would abandon the position.
  • Waiting for the breakout is another way to trade the rectangle. This breakout, like other technical patterns, should ideally occur on above-normal volume. The trader might utilize the measurement technique mentioned below to determine when to consider leaving the deal.
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The Measuring Principle

You may define a precise minimum price objective using the measurement approach. Such a goal should provide you with the impartiality you need to hold through moments of slight countertrend movement.

Any well-defined technical analysis pattern, such as a rectangle or triangle, may be used with the measurement concept. To compute the minimal goal, first determine the pattern’s height. In the instance of ImClone Systems, the computation is as follows:

Top:$47.50
Bottom:$37.50
Height:10.00 points

Figure 3.

Once the height of the pattern has been identified, add the difference to the breakout level for a bullish breakout. The minimum objective is $57.50 since the breakout level is $47.50 and the height is 10 points. Of course, reaching the aim may take some time, so the trader must be patient. Furthermore, the measuring principle is a statement of probability rather than a promise. Regardless of the aim, the trader will closely follow the technical picture of the company.

How was the IMCL rectangle resolved? Bristol Myers Squibb offered $60 per share to purchase the remaining 83% of ImClone. Shareholders who had watched their stock move nowhere for a year and saw the shares end at $46.44 awoke the following morning to discover their stock had opened at $64.16, much beyond the measuring principle’s minimum aim. Those who traded the rectangle in this example were not “square.”

The Bottom Line

In summary, the rectangle is a classic technical analysis pattern defined by horizontal trendlines and limited by major support and resistance. The pattern may be played by buying at support and selling at resistance, or by purchasing the breakout and setting a goal using the measurement concept.

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