The Rectangle Formation

By Melvin Pasternak AAA

The rectangle is a classical technical analysis pattern described by horizontal lines showing significant support and resistance. It can be successfully traded by buying at support and selling at resistance or by waiting for a breakout from the formation and using the measuring principle. (To brush up on support and resistance, read Support And Resistance Reversals.)

The Rectangle in Classical Technical Analysis
The rectangle formation is an example of a "price pattern" in technical analysis. Price patterns derive from the work of Richard Schabaker, considered the father of technical analysis, and Edwards and Magee, who wrote what many consider the bible on the subject. (To learn more about technical analysis, see our Technical Analysis tutorial.)

This period of technical analysis derives from a time when charts were kept by hand on graph paper and even simple moving averages (SMA) had to be maintained by hand or with the use of a large, clunky adding machine. (To learn more about how technological advances changed the world of finance, read From The Printing Press To The Internet and The History Of Information Machines.)

Rather than modern technical analysis, which relies on indicators, such as moving average convergence divergence (MACD), technical analysts assumed that price patterns repeat themselves over and over throughout time. Pattern recognition meant pattern prediction and thus trading profit. (Learn more about moving averages in Moving Average MACD Combo and our Moving Averages tutorial.)

Many of the price patterns are based on geometrical figures. There are ascending, descending and symmetrical triangles, pennants and wedges. Occasionally, more fancifulshapes are seen, such as the head-and-shoulders formation. (For a closer look at the head-and-shoulders pattern, read Price Patterns - Part 2.)

The Rectangle: Supply and Demand in Balance
A price chart or graph may be thought of as an X-ray of supply and demand. Figure 1 describes a rectangle pattern where supply and demand are in approximate balance for an extended period of time. The shares move in a narrow range, hitting resistance at the rectangle's top and finding support at its bottom. The rectangle can occur over a protracted period of time or form quickly amid a relatively wide-ranging series of bounded fluctuations. Schabaker notes that it can approach a square in its proportions. In any case, it is a pattern which shows trader indecision, one in which the bulls and bears are approximately equally powerful. (For a refresher on supply and demand, read Economics Basics: Demand And Supply.)

Figure 1

Most technicians agree, the rectangle can serve as either a reversal or continuation formation. As a reversal pattern, it ends a trend either up or down. As a continuation pattern, it signifies a pause in the prevailing trend, with the expectation that the prior trend will eventually resume. In either case, the rectangle shows a tug of war between buyers and sellers. Ultimately, either accumulation or distribution prevails, and the shares breakout or breakdown. (Read more about how to profit during breakouts and breakdowns in Trading Failed Breaks. Learn about confirming trends in Trend-Spotting With The Accumulation/Distribution Line.)

"Significant" Support and Resistance
The concepts of support and resistance are critical to understanding the rectangle formation.

  • Support is defined as any price point below the current market price where buying should emerge to create, at least temporarily, a pause in a downtrend.
  • Resistance, on the other hand, is any price above the current market price where selling should emerge to create, at least temporarily, a pause in an uptrend.

In a rectangle, what may be referred to as "significant" support or resistance emerges - that is, a price level returned to again and again. Whereas trendlines in technical analysis are typically drawn on a diagonal, the diagramming of support and resistance requires horizontal trendlines. (Read more in Track Stock Prices With Trendlines.)

ImClone Systems: an Example of a Rectangle Formation
Figure 2 of ImClone Systems (IMCL) employs open-high-low-close bars (rather than candlesticks) and is absent of any indicators, such as MACD. The only addition is a 30-week moving average (MA), which could have been calculated in the classical era. (Read about the ImClone meltdown in Trader's Corner - Shoot The Moon…And Hit It!)

Figure 2

Several observations are worth making on this chart. First, note that an intermediate uptrend line, in force for approximately one year, is broken. The break shows the uptrend has ended. Thus, the prolonged rectangle can either be a reversal or consolidation formation. Until there is a breakdown or breakout from the confines of the rectangle - roughly $37.50 to $47.50 - the pattern's interpretation is uncertain.

Second, horizontal lines drawn on the chart denote significant support and resistance. Significant support was first established in September, tested twice in the early part of the year and retested in June. At each test of support, there was sufficient buying interest to drive the stock higher.

Significant resistance at $47.50 was first touched in August, then probed in October, April and July. At each juncture, the sellers overwhelmed buyers, and the stock receded. This vacillation between significant support and resistance creates the rectangle shape.

One final observation is the slope of the 30-week MA. Of all moving averages, this may best describe the trend. It relates to the rectangle by showing the sideways nature of the formation. In an uptrend or downtrend, the 30-week MA will slope up or down, not sideways. Note how in the early stages of the chart it sloped higher, mimicking the uptrend. Later it flattened and began to slope sideways, showing the prolonged consolidation.

Trading the Rectangle
The following are two basic strategies for trading a rectangle:

  • The first is to buy at support and sell at resistance (one can also sell short at resistance and cover the short sale at support). To mitigate risk, in case the stock breaks down from support, a very tight stop can be employed of perhaps 3%. For example, if one bought ImClone at $37.50, the stop-loss would be 3% lower than $37.50 or $1.12. The trader would exit the position if the stock hit $36.38 ($37.50-$1.12).
  • Another method to trade the rectangle is to wait for the breakout. As with all technical patterns, this breakout should ideally occur on above-normal volume. To know when to consider exiting the trade, the trader could use the measuring principle described below. (Learn more about volume in Gauging Support And Resistance With Price By Volume.)

The Measuring Principle
The measuring principle allows you to set a specific minimum price target. Such a target should give you the objectivity to hold during periods of minor countertrend movement.

The measuring principle works with any well-defined technical analysis pattern, such as a rectangle or triangle. To calculate the minimum target, first establish the height of the pattern. In the case of ImClone Systems Figure 3 shows the calculation as follows:

Top: $47.50
Bottom: $37.50
Height: 10.00 points
Figure 3

For a bullish breakout, once the height of the pattern has been established, add the difference to the breakout level. Since the breakout level is $47.50 and the height 10 points, the minimum target is $57.50. Of course, it may take some time to reach the target, so the trader must be patient. As well, the measuring principle is a statement of probability, not a guarantee. The trader will carefully monitor the technical picture of the stock despite the target. (Read more in The Anatomy Of Trading Breakouts.)

How was the rectangle in IMCL resolved? Bristol Myers Squibb bid $60 a share to acquire the 83% of ImClone it did not already own. Shareholders who had seen their stock go nowhere for a year, and saw the shares close at $46.44, woke up the next morning to find their stock had opened at $64.16, well beyond the minimum target set by the measuring principle. Those who traded the rectangle, in this case, turned out not to be "square."

Conclusion
In summary, the rectangle is a classical technical analysis pattern bounded by significant support and resistance and described by horizontal trendlines. The pattern can be traded by buying at support and selling at resistance or buying the breakout and employing the measuring principle to set a target.

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