What Are Rectangles?
Rectangle refers to a pattern in which the price of an asset stays within an upper and lower limit. As the price stays between these limits, bouncing back and forth, a rectangle can be drawn, or seen, around the price action.
Rectangles are also referred to as ranges.
- A rectangle is formed when the price generates at least two swing lows near a similar level and then forms swing highs near a similar level at least twice as well.
- Once the resistance and support are identified, a rectangle can be drawn around the price action.
- Traders attempt to buy near rectangle lows and sell near rectangle highs. Alternatively, they wait for a breakout of the pattern, expecting the price to continue moving in that direction.
What You Need to Know About Rectangles
A rectangle is a technical analysis term for when the price of any asset is moving sideways between resistance and support. Resistance is where people tend to step in to sell and buying dries up, and support is where buyers tend to step in and selling dries up. Support and resistance occur naturally on price charts, typically when buyers and sellers are unsure of the long-term direction of the asset. Until one side becomes more dominant, the price bounces up and down between similar price levels, moving sideways in a rectangle pattern.
The price stays in a rectangle until it doesn't. When buyers become stronger than sellers and are able to push the price above resistance, this will cause an upside breakout of the rectangle.
When sellers overpower the buyers at support, this is a downside breakout of the rectangle.
Some traders opt to trade breakouts, hoping that the price continues to move in the breakout direction. Other traders prefer to buy near the rectangles lows and sell or short near the rectangle highs. In this way, they are trading within the rectangle.
Rectangles, Breakouts, and False Breakouts
In theory, rectangles are a simple pattern that should produce easy profits. One of the main problems with rectangles is that people trading within the pattern don't know when a breakout will occur. Alternatively, people trading breakouts don't know if the breakout will continue to move in the breakout direction or if the price will move right back into the rectangle after triggering them into a trade.
If a breakout occurs on larger-than-average volume, the breakout is more likely to be legitimate and continue to move in the breakout direction. A breakout on low volume, relative to recent volume, means there has been little shift in the psychology of the market and the breakout is likely to be false with the price moving back inside the rectangle.
Example of How to Recognize Rectangles on a Chart
In the chart, Okta Inc. (OKTA) is moving within a rectangle pattern. The price tends to stall out and reverse near $226, and then the price seems to find support and move higher near $193.
Once the price had made at least two lows near the same level, and two highs near the same level, a rectangle can be drawn. Traders can then decide if they wish to wait for a breakout to trade, or they can attempt to sell near resistance and/or buy near support.
On the chart, after the second peak, the rectangle can be drawn. Once the price reaches the top of the rectangle a third time (or more) and starts to fall, a sell signal is generated. Similarly, if the price reaches the bottom of the rectangle a third time (or more), and then starts to rise off it, a long trade could be initiated.
Breakout traders wait for the price to move outside the rectangle on larger-than-average volume.
The Difference Between a Rectangle and a Consolidation
Rectangles and consolidations are similar patterns, but consolidations are smaller. Rectangles typically cover a large price area and a substantial amount of time. A consolidation typically covers a small price area and doesn't last very long because the price is so compressed that it easily breaks out of the small area.
Limitations of Using Rectangles
Rectangles don't necessarily have clean edges, meaning the highs and lows of the rectangle will often be slightly different prices. This makes determining an actual breakout point difficult.
The price may not reach the edges of the rectangle on future attempts. The price could start forming a smaller rectangle, or other price pattern, within the rectangle.
Once a breakout occurs, it may not move in the expected direction. Or it may move in the expected direction, but not very far.
False breakouts occur frequently, which may have negative effects on traders trading breakouts and those trading within the pattern. Some traders wait for a false breakout before entering a trade.
To trade rectangles effectively, traders may wish to incorporate trend analysis and potentially other technical analysis indicators to aid in their decision making.