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:

Price patterns are seen in identifiable sequences of price bars shown in technical analysis charts. These patterns can be used by to examine past price movements and predict future ones for a particular trading instrument. Readers should already be familiar with trendlines, continuation price patterns and reversal price patterns.

In this article, we will explore how to interpret the patterns once they have been identified and examine the rare but powerful triple top and triple bottom patterns.

Duration

The duration of the price pattern is an important consideration when interpreting a pattern and forecasting future price movement. Price patterns can appear on any charting period, from a fast 144-tick chart, to 60-minute, daily, weekly or annual charts. The significance of a pattern, however, is often directly related to its size and depth.

Patterns that emerge over a longer period of time generally are more reliable, with larger moves resulting once price breaks out of the pattern. Therefore, a pattern that develops on a daily chart is expected to result in a larger move than the same pattern observed on an intraday chart, such as a one-minute chart. Likewise, a pattern that forms on a monthly chart is likely to lead to a more substantial price move than the same pattern on a daily chart.

Price patterns appear when investors or traders become used to buying and selling at certain levels, and therefore, price oscillates between these levels, creating patterns such as flags, pennants and the like. When price finally does break out of the price pattern, it can represent a significant change in sentiment. The longer the duration, the harder buyers will have to push to break above an area of resistance (and the harder sellers will have to push to break below an area of support), resulting in a more formidable move once price does break in either direction. Figure 1 shows a pennant price pattern that formed on the weekly chart of Alphabet Inc. (GOOG). Once price continued in its established direction, the upward move was substantial.

Volatility

Similarly, the degree to which price fluctuates within a price pattern can be useful in analyzing the validity of a price pattern, as well as in predicting the magnitude of the eventual price breakout. Volatility is a measurement of the variation of prices over time. Greater price fluctuations indicate increased volatility, a condition that can be interpreted as a more active battle between the bears, who are trying to push prices down, and the bulls, who are trying to push prices up. Patterns showing larger degrees of volatility are likely to result in more significant price moves once price breaks out of the pattern.

Larger price movements within the pattern may signify that the opposing forces—the bulls and the bears—are engaged in a serious battle, rather than a mild scuffle. The greater the volatility within the price pattern, the more anticipation builds, leading to a more significant, possibly explosive, price move as price breaches the level of support or resistance.

Volume

Volume is another consideration when interpreting price patterns. Volume signifies the number of units of a particular trading instrument that have changed hands during a specified time period. Typically, a trading instrument’s volume is displayed as a histogram, or a series of vertical lines, appearing beneath the price chart. Volume is most useful when measured relative to its recent past. Changes in the amount of buying and selling that is occurring can be compared with recent activity and analyzed: Any volume activity that diverges from the norm can suggest an upcoming change in price.

If price breaks above or below an area of resistance or support, respectively, and is accompanied by a sudden increase in investor and trader interest—represented in terms of volume—the resulting move is more likely to be significant. The increase in volume can confirm the validity of the price breakout. A breakout with no noticeable increase in volume, on the other hand, has a far greater chance of failing since there is no enthusiasm to back the move, particularly if the move is to the upside.

Guidelines for Interpreting Patterns

Three general steps help technical analysts interpret price patterns:

1. Identify: The first step in successfully interpreting price patterns is to identify valid patterns in real time. The patterns are often easy to find on historical data but can become more challenging to pick out while they are forming. Traders and investors can practice identifying patterns on historical data, paying close attention to the method that is used for drawing trendlines. Trendlines can be constructed using highs and lows, closing prices or another data point in each price bar.
2. Evaluate: Once a pattern is identified, it can be evaluated. Traders and investors can consider the duration of the pattern, accompanying volume and the volatility of the price swings within the price pattern. Evaluating these can give a better picture regarding the validity of the price pattern.
3. Forecast: Once the pattern has been identified and evaluated, traders and investors can use the information to form a prediction, or to forecast future price movements. Naturally, price patterns do not always cooperate, and identifying one does not guarantee that any particular price action will occur. Market participants, however, can be on the lookout for activity that is likely to occur, enabling them to respond quickly to changing market conditions.

Triple Tops and Bottoms

Triple tops and bottoms are extensions of double tops and bottoms. If the double tops and bottoms resemble an “M” or “W,” the triple tops and bottoms bear a resemblance to the cursive “M” or “W”: three pushes up (in a triple top) or three pushes down (for a triple bottom). These price patterns represent multiple failed attempts to break through an area of support or resistance. In a triple top, price makes three tries to break above an established area of resistance, fails and recedes. A triple bottom, in contrast, occurs when price makes three stabs at breaking through a support level, fails and bounces back up.

A triple top formation is a bearish pattern since the pattern interrupts an uptrend and results in a trend change to the downside. Its formation is as follows:

• Prices move higher and higher and eventually hit a level of resistance, falling back to an area of support.
• Price tries again to test the resistance levels, fails and returns toward the support level.
• Price tries once more, unsuccessfully, to break through resistance, falls back and through the support level.

This price action represents a duel between buyers and sellers; the buyers try to lift prices higher, while the sellers try to push prices lower. Each test of resistance is typically accompanied by decreasing volume, until price falls through the support level with increased participation and corresponding volume. When three attempts to break through an established level of resistance have failed, the buyers generally become exhausted, the sellers take over and price falls, resulting in a trend change.

Triple bottoms, on the other hand, are bullish in nature because the pattern interrupts a downtrend and results in a trend change to the upside. The triple bottom price pattern is characterized by three unsuccessful attempts to push price through an area of support. Each successive attempt is typically accompanied by declining volume, until price finally makes its last attempt to push down, fails and returns to go through a resistance level. Like triple tops, this pattern is indicative of a struggle between buyers and sellers. In this case, it is the sellers who become exhausted, giving way to the buyers to reverse the prevailing trend and become victorious with an uptrend. Figure 2 shows a triple bottom that once developed on a daily chart of McGraw Hill shares.

A triple top or bottom signifies that an established trend is weakening and that the other side is gaining strength. Both represent a shift in pressure: With a triple top, there is a shift from buyers to sellers; a triple bottom indicates a shift from sellers to buyers. These patterns provide a visual representation of the changing of the guard, so to speak, when power switches hands.

Bottom Line

Price patterns occur on any charting period, whether on fast tick charts used by scalpers or yearly charts used by investors. Each pattern represents a struggle between buyers and sellers, resulting in the continuation of a prevailing trend or the reversal of the trend, depending on the outcome. Technical analysts can use price patterns to help evaluate past and current market activity, and forecast future price action in order to make trading and investing decisions.