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Stock Trading Strategies > Technical Analysis  >  Chart Patterns

Rectangle Chart Patterns

Technically speaking, a rectangle is a rally to a relative new high, pullback to an intermediate support level, a second rally to test the new high, a second pullback to intermediate support, a third rally to test the new high level followed by an upside breakout on strong volume.

Why Does It Happen?

At first and perhaps even second glance, a rectangle may seem to be little more than another variation of the double top pattern but while the two technical formations do share some important characteristics, we need to remember that the double top is a reversal pattern while the rectangle is continuation pattern.  Rectangles almost always take shape after a stock has been trending strongly and typical last 4 - 6 weeks in duration.  Although the fundamental news that gave birth to the strong trend is still valid, investors need an opportunity to digest the recent move.  The stock falls into a "holding pattern" delineated by near horizontal support and resistance zones.  During this phase both support and demand are roughly in equilibrium.  Buyers may still like the stock but they are not willing to "chase" the price significantly higher.  Thus they choose to take profits into strength to a certain level and become aggressive buyers on a pullback to a certain level.  The pattern begins when a well-liked stock moves to a new high on strong volume.  As the "story" of the stock becomes more widely accepted investors are willing to pay increasingly exorbitant prices but one day investors find the price is simply too high, the stock puts-in a top and prices begin to fall (top#1)

This first top will normally be sufficient to force many of the more speculative investors from the stock.  As they sell the price of the stock falls further but many investors will not sell regardless of how far the price falls because they refuse to take a loss.  After several sessions (sometimes weeks) of poor price performance the stock will begin to stabilize (reaction low) then gradually move higher.   In most cases this second advance will occur because of some fundamental factor like a positive fundamental development.  As the stock rises volume slows and investors who bought at the first top get ready to exit positions into further strength.   This selling pressure creates a surge in volume and the stock soon retreats (top #2). 

As the second top is created, sentiment turns more bearish.  Although the flow of news is still positive, pundits begin to talk about rich valuations and buyers step back.  At this time speculators begin to add short positions, sensing that a larger decline is about to unfold.  The stock works gradually lower and volume begins to accelerate.  In short order the stock is once again testing the reaction low and sentiment is bearish but somehow, the stock manages to hold that key support level and work modestly higher on stronger volume.  A subtle rally begins but speculators continue to add short positions because sentiment remains poor.  Days later a positive fundamental development occurs and the stock begins to move toward tops #1 and #2 on heavy volume.   The next session Wall Street analysts make positive comments and the stock surges through what had been key resistance at the old highs.   Speculators begin to panic and their short covering during a period when supply of stock is limited leads to further gains.  A new trending phase begins and the stock moves to substantial new highs in the weeks ahead.

How Are Technical Targets Derived?

The technical target for a rectangle is derived by adding the point difference between top#1 and the reaction low to the new breakout level.    

Rectangle for Hewlett Packard

Vital Signs

  • Rectangles are continuation patterns and that means they typically represent little more than a brief period of consolidation in a strong trend.  Although we have written about a rectangle in an uptrend, these patterns are just as likely to occur in downtrends.

  • Rectangles are usually 4 - 6 weeks in duration and always feature very well-defined support and resistance levels characterized by horizontal lines.

  • During the rectangle phase, supply and demand is said to be near equilibrium as buyers catch their breath and attempt to digest the most recent trending period.

  • Upside breakouts often lead to small 2-3% rallies followed by an immediate test of the breakout level.  If the stock closes below this level (now support) for any reason the pattern becomes invalid.

We now know that rectangles have a great deal in common with the other "square" patterns.  Now let's take a look at technical patterns with different geometry, triangles.   

cup with handle      ascending triangle

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