9# Rectangle Continuation
Rectangle is a rally to a relative new high, pullback to an intermediate support level, a second rally to test the new high, a second pullback to intermediate support, a third rally to test the new high level followed by an upside breakout on strong volume.
The technical target for a rectangle is derived by adding the point difference between top#1 and the reaction low to the new breakout level.
• Rectangles are continuation patterns and that means they typically represent little more than a brief period of consolidation in a strong trend. Although we have written about a rectangle in an uptrend, these patterns are just as likely to occur in downtrends.
• Rectangles are usually 4 - 6 weeks in duration and always feature very well-defined support and resistance levels characterized by horizontal lines.
• During the rectangle phase, supply and demand is said to be near equilibrium as buyers catch their breath and attempt to digest the most recent trending period.
• Upside breakouts often lead to small 2-3% rallies followed by an immediate test of the breakout level. If the stock closes below this level (now support) for any reason the pattern becomes invalid.
Rectangle may seem to be little more than another variation of the Double Top patternbut while the two technical formations do share some important characteristics, the Double Top is a reversal pattern while the rectangle is continuation pattern. Rectangles almost always take shape after a stock has been trending strongly and typical last 4 - 6 weeks in duration. Although the fundamental news that gave birth to the strong trend is still valid, investors need an opportunity to digest the recent move. The stock falls into a "holding pattern" delineated by near horizontal support and resistance zones.
During this phase both support and demand are roughly in equilibrium. Buyers may still like the stock but they are not willing to "chase" the price significantly higher. Thus they choose to take profits into strength to a certain level and become aggressive buyers on a pullback to a certain level. The pattern begins when a well-liked stock moves to a new high on strong volume. As the "story" of the stock becomes more widely accepted investors are willing to pay increasingly exorbitant prices but one day investors find the price is simply too high, the stock puts-in a top and prices begin to fall (#1).
This first top will normally be sufficient to force many of the more speculative investors from the stock. As they sell the price of the stock falls further but many investors will not sell regardless of how far the price falls because they refuse to take a loss. After several sessions (sometimes weeks) of poor price performance the stock will begin to stabilize (reaction low) then gradually move higher. In most cases this second advance will occur because of some fundamental factor like a positive fundamental development. As the stock rises volume slows and investors who bought at the first top get ready to exit positions into further strength.
This selling pressure creates a surge in volume and the stock soon retreats (top #2). As the second top is created, sentiment turns more bearish. Although the flow of news is still positive, pundits begin to talk about rich valuations and buyers step back. At this time speculators begin to add short positions, sensing that a larger decline is about to unfold. The stock works gradually lower and volume begins to accelerate. In short order the stock is once again testing the reaction low and sentiment is bearish but somehow, the stock manages to hold that key support level and work modestly higher on stronger volume.
A subtle rally begins but speculators continue to add short positions because sentiment remains poor. Days later a positive fundamental development occurs and the stock begins to move toward tops #1 and #2 on heavy volume. The next session Wall Street analysts make positive comments and the stock surges through what had been key resistance at the old highs. Speculators begin to panic and their short covering during a period when supply of stock is limited leads to further gains. A new trending phase begins and the stock moves to substantial new highs in the weeks ahead.
A rectangle is a continuation pattern that forms as a trading range during a pause in the trend. The pattern is easily identifiable by two comparable highs and two comparable lows. The highs and lows can be connected to form two parallel lines that make up the top and bottom of a rectangle. Rectangles are sometimes referred to as trading ranges, consolidation
zones or congestion areas. There are many similarities between the rectangle and the symmetrical triangle. While both are usually continuation patterns, they can also mark trend significant tops and bottoms. As with the symmetrical triangle, the rectangle pattern is
not complete until a breakout has occurred. Sometimes clues can be found, but the direction of the breakout is usually not determinable beforehand.
1. Trend: To qualify as a continuation pattern, a prior trend should exist. Ideally, the trend should be a few months old and not too mature. The more mature the trend, the less chance that the pattern marks a continuation.
2. 4 points: At least two equivalent reaction highs are required to form the upper resistance line and two equivalent reaction lows to form the lower support line. They do not have to be exactly equal, but should be within a reasonable proximity. Although not a prerequisite, it is preferable that the highs and lows alternate.
3. Volume: As opposed to the symmetrical triangle, rectangles do not exhibit standard volume patterns. Sometimes volume will decline as the pattern develops. Other times volume will gyrate as the prices bounce between support and resistance.
Rarely will volume increase as the pattern matures. If volume declines, it is best to look for an expansion on the breakout for confirmation. If volume gyrates, it is best to assess which movements (advances to resistance or declines to support) are receiving the most volume. This type of volume assessment could offer an indication on the direction of the future breakout.
4. Duration: Rectangles can extend for a few weeks or many months. If the pattern is less than 3 weeks, it is usually considered a flag, also a continuation pattern. Ideally, rectangles will develop over a 3-month period. Generally, the longer the pattern, the more significant the breakout. A 3-month pattern might be expected to fulfill its breakout projection. However, a 6-month pattern might be expected to exceed its breakout target.
5. Breakout Direction: The direction of the next significant move can only be determined after the breakout has occurred. As with the symmetrical triangle, rectangles are neutral patterns that are dependent on the direction of the future breakout. Volume patterns can sometimes offer clues, but there is no confirmation until an actual break above resistance or break below support.
6. Breakout Confirmation: For a breakout to be considered valid, it should be on a closing basis. Some traders apply a filter to price (3%), time (3 days) or volume (expansion) for confirmation.
7. Return to Breakout: A basic tenet of technical analysis is that broken support turns into potential resistance and visa versa. After a break above resistance (below support), there is sometimes a return to test this newfound support level (resistance level). (For more detail, see this article on support and resistance.) A return to or near the original breakout level can offer a second chance to participate.
8. Target: The estimated move is found by measuring the height of the rectangle and applying it to the breakout. Rectangles represent a trading range that pits the bulls against the bears. As the price nears support, buyers step in and push the price higher. As the price nears resistance, bears take over and force the price lower. Nimble traders sometimes play these bounces by buying near support and selling near resistance. One group (bulls or bears) will exhaust itself and a winner will emerge when there is a breakout. Again, it is important to remember that rectangles have a neutral bias. Even though clues can sometimes be gleaned from volume patterns, the actual price action depicts a market in conflict. Only until the price breaks above resistance or below support will it be clear which group has won the battle.