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.

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.

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.

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.

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.

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.

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.

“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.

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.

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.

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:

The iPath S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note (ETN) designed to provide investors with exposure to equity market volatility. Shares of an ETN, which is structured as a debt instrument, can be bought and sold like shares of stock.

During times of high volatility in the stock market, the value of VXX shares will typically increase. On the other hand, quiet periods for the market will likely keep shares trending lower. Here’s why.

Understanding VXX

The iPath S&P 500 VIX Short-Term Futures ETN is legally structured as an exchange-traded note (ETN), which is similar in nature to an exchange-traded fund (ETF). The main difference between an ETF and an ETN is that, while the exchange-traded fund represents ownership in a basket of securities—stocks, bonds, or commodities—within the fund’s portfolio, the exchange-traded note is an uncollateralized debt instrument and has bond-like characteristics: investors can hold shares until maturity (which is Jan. 23, 2048, for the VXX ETN launched Jan. 19, 2018) and buy and sell before maturity.

Managed by Barclays Capital Incorporated, the iPath S&P 500 VIX Short-Term Futures ETN is linked to the daily price changes in Cboe Volatility Index, but in a complicated way. VIX is sometimes called the market’s “fear gauge” because it tends to rise during periods of market uncertainty and spike in times of panic. The index tracks changes in the expected volatility priced into S&P 500 Index options and is computed using an options-pricing formula.

Futures contracts are listed on Cboe Volatility Index, and VXX is an ETN that tracks the S&P 500 VIX Short-Term Futures Total Return Index, which is designed to offer exposure to long positions in Cboe Volatility Index futures contracts. Therefore, VXX does not track VIX itself (spot VIX), but the futures on VIX, which often trade at very different price levels depending on the time to maturity.

Risks

Since VXX must roll its futures contracts to rebalance the fund to the later contract, the fund manager is forced to sell the futures contracts that are closest to their expiration dates and buy the next dated contracts, which is a process called rolling. Since longer-dated futures contracts are often at higher levels than shorter-dated ones (during normal market conditions), the rolling activity can result in losses (as the ETN is forced to sell the lower-valued contracts and buy the higher-priced contracts).

The iPath S&P 500 VIX Short-Term Futures ETN can be influenced by many unpredictable factors, and the price of VXX can fluctuate substantially between now and the maturity date. Influential factors include prevailing market prices of the U.S. stock market, S&P 500 Index options prices, supply and demand for VXX, as well as economic, political, regulatory or judicial events, or changes to interest rate policies. Basically, anything that affects stock prices can also affect volatility and VXX shares.

The Bottom Line

An investment in VXX might be suitable for investors who want to hedge their portfolios against a market downturn and speculators who have a high risk tolerance. However, since the iPath S&P 500 VIX Short-Term Futures ETN is only composed of derivative contracts, individuals should understand the Cboe Volatility Index and VIX futures before investing or trading the exchange-traded note.

One of the main goals of every trader using technical analysis is to measure the strength of an asset’s momentum and the likelihood that it will continue. Momentum measures the speed at which the price of a security is moving, and there are a variety of indicators one can look at to measure this.

Most of the indicators used to measure momentum are interpreted by using certain values that suggest the asset may be getting overbought or oversold, which is a weakening of momentum, and would signal a reversal in the trend.

Momentum indicators are bound between two extreme levels. This is important because a cross through the center line of the indicator is interpreted to mean that momentum is either increasing or decreasing and that acts as an indicator to buy or sell.

Some of the main tools to measure momentum are the moving average convergence divergence (MACD), stochastics oscillator, price rate of change (ROC), and the relative strength index (RSI).

Moving Average Convergence Divergence (MACD)

The MACD depicts the relationship between two moving averages of a security’s price. It is calculated by subtracting the 26-period exponential moving average from the 12-period exponential moving average. When this is calculated, a MACD line is created and a nine-period MACD line, known as the “signal line,” is transposed over the MACD line. This then functions as a trigger to buy or sell depending on where the MACD crosses the signal line.

Rate of Change

The rate of change is the speed at which a variable changes over a specific period of time. It is expressed as a ratio between a change in one variable relative to a corresponding change in another. Graphically, the rate of change is represented by the slope of a line and mathematically as the percentage change in value over a specific period of time and represents the momentum of a variable.

To calculate the ROC, one takes the current value of a stock and divides it by the value from a previous period, then subtracts one and multiplies by 100 for the percentage figure.

Rate of Change = [(Current Value of Stock/Previous Value of Stock) – 1]*100

A security with a high momentum has a positive ROC and outperforms the market in the short term whereas a low momentum security has a negative ROC and is likely to decline in value, which can be seen as an indicator to sell.

Stochastic Oscillator

The stochastic oscillator seeks to measure the closing price of a security to a range of its historical prices over a defined period of time. It is used to generate overbought and oversold trading signals using a 0–100 bounded range of values. Values over 80 are considered to be in the overbought range and values below 20 are considered to be in the oversold range. When values reach these points, they typically indicate a reversal of the trend.

Relative Strength Index (RSI)

The RSI measures the magnitude of recent price changes. The RSI looks at average gains or losses over 14 trading periods. Much like the stochastic oscillator, it uses a bounded range value of 0 to 100 to mark overbought or oversold conditions in the price of an asset. Values that are 70 or above indicate an overbought security, whereas values of 30 and below indicate an oversold condition.