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THE CHARTIST


Between The Lines Of Rectangle Patterns

01/14/13 09:53:49 AM PST
by Bruce Tintelnot

It’s an area of indecision -- are the bulls in control or bears?

Ever had prices stall on a well-defined trend on a chart or get stuck in a consolidation? I’ll bet you have. In a range-bound market, prices move between a consistent upper resistance and a lower support for short or extended periods of time. Support and resistance lines form a rectangle pattern. It is considered to be an area of indecision -- are the bulls in control or bears? It is an area of relatively equal market pressure in both directions, sometimes referred to as sideways trending, and because of this it can be either a continuation pattern or a reversal pattern.

HOW ARE RECTANGLES DETERMINED?
The market pressure keeps the prices bound in a range between significant resistance and support. These areas can be determined by drawing a line that connects the two uppermost points and another line that connects the two lowermost. These lines should be unbroken and parallel to each other to form a rectangle pattern. When these lines are broken, one of the basic tenets of technical analysis comes into play; their roles reverse for the new prices, broken resistance becomes support, and the broken support becomes resistance.

The duration of a rectangle pattern varies. It can last from two or three weeks to six months on daily charts. There is usually no particular volume pattern associated with rectangles.

HERE’S AN EXAMPLE
The chart of Donaldson Co. (DCI) in Figure 1 shows two rectangle formations. The first one begins in February 2011 with resistance at $31 and ends in July 2011 with a downward breakout through support at $27. Prices trended upward from there through what are now two resistances at $27 and $31 to form another rectangle in May 2012 with new resistance around $36.60. The previous rectangle’s resistance became the new rectangle’s support at $31. If prices keep trending in the direction of the 200-day moving average, the most likely direction of a breakout would be upward through the $36.60 resistance.



FIGURE 1: RECTANGLE FORMATIONS. Here you see two rectangle formations: the first one begins in February 2011 with resistance at $31 and ends in July 2011 with a downward break out through support at $27. Prices trended upward from there through the second rectangle, with two resistances at $27 and $31 to form another rectangle in May 2012 with new resistance around $36.60. The previous rectangle’s resistance became the new rectangle’s support at $31.

HOW ARE RECTANGLES TRADED?
The rectangle is an interesting pattern due to its symmetry and balanced behavior from the bulls and bears trying to work through a state of indecision. Instead of prices being bound in angular lines, as in other similar patterns like triangles and pennants, they are formed by two horizontal lines of support and resistance. The price movements can seem like a microcosm of what goes on in the larger marketplace. This is good to keep in mind when trying to trade within this formation.

To the best of my knowledge, there are only two ways to trade rectangle patterns. One way is to sell when prices reach their resistance and to buy when prices touch support. Momentum indicators are the most frequently used tools for trading when prices are in a rectangle. Trend indicators are not useful for this. Some of the most common momentum indicators are the relative strength index (RSI), the stochastic oscillator, rate of change (ROC), and Williams’ %R.

Another way to trade a rectangle is to determine when and in which direction prices will break out of the pattern. Breakouts are often dramatic and can seem as though the bulls or bears are trading with renewed energy after a respite. Momentum indicators are not going to show when prices will break through the support or resistance areas, but if a trend indicator looks strong, it may indicate a continuation. In Figure 1, the 200-day moving average indicates a strong trend because prices are staying well above it and have not even come close to crossing below it.

When you are entering a trade, it is always good to have a price target. This helps maintain a focus on the technical aspects of the trade and stay as free as possible of emotional reactions to market movements. Experience is the most important watchword. But how do you determine price targets?

The measuring principle is a common method for determining a price target when breakouts occur. It’s not a firm rule, but it can provide a good minimum target price for a trade. The target price is calculated by subtracting the support price from the resistance price, then adding it to the resistance for an upward breakout or by subtracting it from the support for a downward breakout.

Figure 1 shows that subtracting the $27 support from the $31 resistance provides a target of $35 for an upward breakout continuing the trend. This turned out to be conservative as the price reached $38.69 before receding into another rectangle pattern. A target for a downward breakout would have been $23 ($27 - $4), which was actually reached bottoming at $22.89 before the prices rebounded to continue the prevailing trend.

A center line drawn through a rectangle can form another good reference point for trades equally as important as the support and resistance that contains the pattern. This area serves the dual purpose of an intermediate support or resistance area for prices and can sometimes be indicated by a moving average adjusted for the particular time frame being used.

IT’S GOING SIDEWAYS
Rectangle patterns on a price chart are considered to be neutral formations where the bulls and bears are struggling in a tug of war trying to continue the prevailing trend or reverse it. Trading the pattern can be as simple as buying when prices reach resistance and selling when they descend to support. This can be confirmed through the use of momentum indicators.

Breakouts are usually dramatic and can turn over large profits to those who catch them at the right time, but they are also difficult to determine as there are no direct warnings indicating their direction. Due to the neutrality of this formation and its sideways direction, much of the price movement within it can epitomize the larger market and principles that apply there can also be used in this microcosm.

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Bruce Tintelnot

Bruce Tintelnot is a private trader and freelance writer.



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