A "rectangle" is a fairly common price pattern which is typically defined by a tight trading range that highlights a battle between buyers and sellers. A completed rectangle pattern can yield some very useful indications regarding whether a trend will continue or reverse.
Rectangle pattern types
The three types of rectangle patterns are:
- Rectangle top, a bearish reversal pattern
- Rectangle bottom, a bullish reversal pattern
- Continuation or consolidation rectangles, continuation patterns
What the rectangle pattern signals
As a rectangle pattern forms it signals a struggle between bullish and bearish traders to take control and drive price in a particular direction. Volume levels can be useful in helping to determine if the pattern will indeed fully form or if it is getting close to completing the pattern. Once a rectangle pattern is completed a trader can effectively identify it as "rectangle top", a "rectangle bottom" or a "continuation rectangle."
How a rectangle pattern forms
The rectangle pattern is formed when:
1. The price of a stock reaches a certain point and begins to meet pressure from the opposite direction.
2. At this point, sentiment turns the other way and the opposition changes the direction of the price until it meets heavy and seemingly immovable pressure at a former point of interest. At that point the sentiment changes again, and the price once again moves back in the opposite direction.
3. This cycle can repeat itself a number of times and as it occurs it highlights an ongoing tug-of-war between buyers and sellers for effective control of price direction. This action causes price to consolidate and trade within a "range" that can be readily observed on a price chart. These ranges can be more clearly seen by drawing a resistance line at the top of the range and a support line at the bottom of the range. Drawing vertical lines connecting the high and low of the range creates a rectangle on the price chart.
There may be times when price momentarily breaks through the support or resistance level for a particular rectangle pattern, only to reverse back into the range. So patience is in order when observing the formation and completion of a rectangle pattern. It is important to observe the price not only breaking through a support or resistance line, but then also staying there for a few periods to further confirm the validity of the breakthrough. Remember, until the price breaks through support or resistance and remains outside of the pattern, the pattern is not complete.
Ideally an upside breakout above resistance will be accompanied by large and/or increasing volume. If volume is relatively low and/or shrinking during or just after the breakout it suggests that the breakout may not be sustainable. An increase in volume as price breaks out of a formed rectangle can serve as a useful confirmation signal that the rectangle pattern is completed.
How traders use the pattern to determine price targets
One technique used by many traders is to use the high to low range of a given rectangle pattern to project how far a stock or other asset might run after it breaks outside of the rectangle pattern. This price projection is achieved simply by measuring the distance in points between resistance (the high of the rectangle pattern) and support (the low of the rectangle pattern).
This amount is then added to the resistance level price to project an upside price target, or subtracted from the support level to project a downside target.
Price patterns offer clues as to what the majority of traders are thinking and doing in regards to a given stock or other asset. As it forms, a rectangle pattern highlights a back and forth struggle between bulls and bears. A breakout from a rectangle pattern suggests that one side has gotten the upper hand in that struggle and typically argues for a continuation in the direction of the breakout.