Chart Patterns: Rectangles

The rectangle is a familiar geometric form that most people study in grade school, but in technical price analysis, it can take on a special significance. For technical analysts, rectangles are normally understood as patterns that indicate the continuation of a price trend. The rectangle may be identified by other names, such as a trading range, a line, or a congestion pattern.

How To Identify A Rectangle On A Chart

A rectangle occurs in a period of consolidation, when the market lacks conviction about either a strong price move upward or downward. Like other continuation patterns, the rectangle is formed by a series of two or more successive highs or lows that are roughly the same size. When these appear, traders can draw a line across the tops of the highs to indicate a level of resistance and across the lows to indicate a level of support.

Trading With Rectangles

There are a few possibilities for trading with the rectangle pattern. The first and most obvious is to trade on the price breakout. In this strategy, traders want to wait for the price to definitively break outside of the range defined by support and resistance to go long or short on an asset. A definitive break is typically detected when a closing price is outside the range. Traders going long can set a price target above the range at a point equal to the height of the rectangle, and set a stop loss for protection at the midpoint of the height of the rectangle.

The appearance of a rectangle can sometimes signal range-bound conditions, so an alternative to trading for a breakout is to trade the swings within the rectangle. To set up this trade, traders can enter long at the low point of a price swing, setting a stop loss below the entry point and target a move up to resistance.

Rectangle Or Triple Top?

Traders may need to be cautious when analysing and trading on the rectangle, because it can be confused with other patterns, such as triple or multiple tops or bottoms. The key difference between the rectangle and the triple top or bottom is the direction and extent of any breakout and the volume that accompanies it.

In a rectangle, traders see a significant continuation of the trend that preceded the formation of the pattern and an uptick in volume. This makes the rectangle more similar to a wedge pattern, where the trend continues at the end of a formation. By contrast, in a triple top or triple bottom formation, traders see a breakout from range-bound conditions toward a reversal of the preceding trend.

OCO – One Cancels Other Order

On occasion, when conditions permit, a rectangle pattern can break out in an unexpected manner toward a reversal. To adjust for this possibility, traders can employ an OCO, or "one cancels other" order. An OCO, also known as a "bracket order," allows traders to simultaneously create two entry orders, one above the current market price and one below it. The entry orders are linked together, meaning if one of the two orders is executed, the other will automatically be canceled.

The Importance Of Volume

As with other breakout signals, traders want to monitor volume closely to determine whether a price movement will be consolidated. This is based on the observation that when a trend gathers strength, trading volume tends to pick up, and volume tends to fall off when a trend is weakening. Some of the convenient volume indicator tools that can be consulted include volume-moving average, price-volume trend, relative strength index, and on-balance volume.^[1]

Summary

The rectangle pattern is a common and easily identifiable formation on charts when prices momentarily move into range-bound behaviour. Because of the pattern's relative stability, it offers varying possibilities for setting up trades. The appearance of a rectangle generally indicates a continuation of a trend and thus is considered a reliable signal prefiguring a breakout.

However, traders can also use support and resistance defined by the formation to carry out swing trading within the pattern. Additionally, depending on market conditions, prices forming a rectangle on occasion can also move in an unexpected direction toward a reversal. When there is uncertainty about the direction signaled by the pattern, traders can take recourse to OCO orders that allow for trading a price breakout in either an upward or downward direction.

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