What Is a Rectangle?
A rectangle is a pattern that occurs on price charts. A rectangle is formed when the price reaches the same horizontal support and resistance levels multiple times. The price is confined to moving between the two horizontal levels, creating a rectangle. The concept of a rectangle is similar to a Darvas Box.
- A rectangle occurs when the price is moving between horizontal support and resistance levels.
- The pattern indicates there is no trend, as the price moves up and down between support and resistance.
- The rectangle ends when there is a breakout, and the price moves out of the rectangle.
- Some traders like to trade the rectangles, buying near the bottom and selling or shorting near the top, while others prefer to wait for breakouts.
What Does a Rectangle Tell You?
A rectangle is a technical analysis pattern made on a chart. The term refers to an instance in which the price of a security is trading within a bounded range where the levels of resistance and support are parallel to each other, resembling the shape of a rectangle.
The bounded range, or rectangle, generally occurs when investors are indecisive about the long-term direction of a security. So, it rises and falls within the defined range, unable to make headway either way.
In a rectangle pattern, investors will see the price of the security test the levels of support and resistance several times before a breakout. Once the security breaks out of the rectangle’s range, in either direction, it is considered to be trending in the direction of the breakout. Not all breakouts end up being successful. For example, the price could break out of the rectangle to the upside and fall back into the rectangle shortly after. That is called a failed break.
Examples of How to Use a Rectangle
There are several ways to trade a rectangle. The two main methods are to try to capture profit while the price moves back and forth within the rectangle or wait for breakouts.
Trading the rectangle requires identifying the pattern early. Since a breakout is likely to occur eventually, the range or rectangle trader is hoping to get in a few successful trades before that happens.
- They attempt to buy near support, as the price turns up. A stop loss is placed below support, and a profit target is set below resistance.
- They attempt to short near resistance, as the price turns down. A stop loss is placed above resistance, and a profit target goes above support.
If the price breaks out of the rectangle, this will result in a losing trade for these traders. The price will break through support or resistance, and their stop loss will be triggered.
When the price breaks through support or resistance, the breakout trader springs into action. They buy if the price moves above resistance, or they short if the price falls below support. They place a stop loss in case the price reverses on them. Some traders like to take the rectangle's height and then add it to the rectangle's top for an upside breakout (or subtract the height from the bottom of the rectangle on a downside breakout). That provides them with a profit target.
For example, assume the price is ranging between $48 and $50 for several weeks. Finally, the price breaks above $50. The height of the range, $2, is added to the top of the range, $50, providing a target of $52. If the price broke to the downside, the target is $46.
These tactics sound simple, but they are not so simple to implement in the real world. Usually, the price won't stall at the exact same support or resistance each time the price visits the area. Determining where to go long or short, or when a breakout occurs, isn't always clear.
There are multiple variations of these basic methods, such as using a trailing stop loss for the exit or using technical indicators to aid with the entry timing.
Real-World Example of a Rectangle
The following chart shows a rectangle that occurred within Toronto Dominion Bank (TD) stock. The price moves sideways, topping out and bottoming at a similar price on each price swing. Eventually, the price breaks below the rectangle, and the price falls sharply.
During the rectangle, the price action converged into a narrower range. This process formed another chart pattern called the triangle. The price broke below the low of the triangle before dropping below the low of the rectangle.
Rectangle vs. Head and Shoulders Pattern
A rectangle is a period where the price is moving sideways. A head and shoulders pattern is where the price is transitioning from an uptrend to a downtrend. The price is making higher peaks on the left side and then a lower peak on the right. It shows the uptrend may be reversing.
Limitations of the Rectangle Chart Pattern
A rectangle is easy to spot but not so easy to trade. The price won't always reach the prior support or resistance levels, and sometimes it will exceed them. That can trick traders, resulting in missed or losing trades.
False breakouts are plentiful during rectangles. Some traders actually prefer to wait for a false breakout and then place a trade betting that the range will continue.
Some breakouts will result in huge profits as the price explodes out of the rectangle with a big move. Many rectangles will end with minimal price movement. In some cases, the price moves out of the range and then starts ranging again.