Rectangle
A Rectangle is a continuation pattern that forms during a pause in the trend. It is easily identifiable by two comparable highs and two comparable lows, which 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.
The chart below is an example of a typical Rectangle pattern.
There are many similarities between the rectangle and the symmetrical triangle. While both are usually continuation patterns, they can also mark significant tops and bottoms in trends. As with the symmetrical triangle, the rectangle pattern is incomplete until a breakout occurs. Sometimes, you can find clues, but the direction of the breakout is usually not determinable beforehand. We will examine each component of the rectangle pattern followed by an example.
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.
Four (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 don't have to be exactly equal but should be reasonably close. Although not a prerequisite, it's preferable that the highs and lows alternate.
Volume. Unlike symmetrical triangles, rectangles don't exhibit standard volume patterns. Sometimes, volume will decline as the pattern develops. Other times, volume will be choppy as price bounces between support and resistance. Volume will rarely increase as the pattern matures. If volume declines, it's best to look for an expansion on the breakout for confirmation. If volume is choppy, assessing which movements (advances to resistance or declines to support) are receiving the most volume is best. This type of volume assessment could offer an indication of the direction of the future breakout.
Duration. Rectangles can extend for a few weeks or many months. If the pattern is less than three weeks, it's generally considered a flag, a continuation pattern. Ideally, rectangles will develop over three months. Generally, the longer the pattern, the more significant the breakout. A three-month pattern might be expected to fulfill its breakout projection. However, a six-month pattern might be expected to exceed its breakout target.
Breakout Direction. The direction of the next significant move can only be determined after the breakout. As with the symmetrical triangle, rectangles are neutral patterns dependent on the direction of the future breakout. Volume patterns can sometimes offer clues, but there's no confirmation until an actual break above resistance or below support.
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 (three days), or volume (expansion) for confirmation.
Return to Breakout. A basic tenet of technical analysis is that broken support turns into potential resistance and vice 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 our ChartSchool article on support and resistance.) A return to or near the original breakout level can offer a second chance to participate.
Target. The estimated move is found by measuring the rectangle's height and applying it to the breakout.
Rectangles represent a trading range that pits the bulls against the bears. Buyers step in and push the price higher as the price nears support. 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 after 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 when the price breaks above resistance or below support will it be clear which group has won the battle.
In the summer of 1999, Micron Electronics (MU) advanced from the high teens to the low forties. After meeting resistance around 42, the stock settled in a trading range between 40 and 30 to form a rectangle.
The advance from the high teens to the low forties established the prior intermediate trend as bullish. However, it was unclear at the time whether this trading range would be a reversal or a continuation pattern. The horizontal resistance line at $40 can be extended back to the February 1999 high and marked a serious resistance level.
The red resistance line at $40 was formed with three reaction highs. The first reaction high may be a bit suspect, but the second two are robust. The parallel support line at $30 was touched three times and established a solid support level. After the high at point 5 was reached, the rectangle was valid.
As the pattern developed, volume fluctuated, and there was no clear indication (bullish or bearish break) until mid-February. The first bullish clue came when the stock declined from $38 to $31, and Chaikin Money Flow (CMF) failed to move below -10%. Money flows held steady throughout the decline and turned positive when the stock turned back up. By the time the stock reached $39.75 (surpassing its previous reaction high), CMF was at +20%. Also, notice the strength behind the advance after a higher low.
The duration of the pattern was five months. Due to long-term overhead resistance at $40, the pattern needed more time to consolidate before a breakout. The longer consolidation made for bigger expectations after the breakout.
The breakout occurred with a large expansion in volume and a large move above resistance.
After the breakout, there was a slight pullback to around $46, but the volume behind the advance indicated a huge breakout. Stocks don't always return to the point of breakout. In the chart of LMT (first chart at the top of the page), you see that the stock price makes a classic return to the breakout. It's best to evaluate the setup and strength behind the breakout to determine the likelihood of a second chance opportunity.
The target advance of this breakout was 10 points, the width of the pattern. However, judging from the duration and strength of the breakout, volume expansion, and new all-time highs, it was apparent that this was no ordinary breakout; therefore, an ordinary target was useless. After an initial advance to $55.81, the stock pulled back to $46 and then moved above $70. Subsequently, another trading range developed with resistance in the low $70s and support in the upper $40s.
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