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Rectangles Explained

Beginner

What is a rectangle pattern?

The rectangle is a consolidation pattern that signals a pause within a trend. The rectangle pattern develops between lines of horizontal support and resistance. However, importantly, they are seen as continuation patterns, with the pause coming before a breakout in the direction of the prevailing trend.

The opposite of a consolidation rectangle is a top or a bottom. Where a rectangle is seen as a continuation pattern, tops and bottoms are seen as reversal patterns.

The pattern formation

Here are a few features of the formation of a rectangle:

  • The rectangle is a pause within a trend. So it needs a decisive trend coming into the pattern.
  • The market then consolidates within horizontal lines of support and resistance that build up. Ideally, this would be at least three tests of the support and resistance.
  • The market then posts a breakout in the direction of the prevailing trend.
The pattern formation

There are various ways of trading a rectangle:

  1. Trade the consolidation. Traders taking the view that the rectangle will continue will look to buy around the rectangle lows and sell around the rectangle highs. If there is a confirmed break of the rectangle support or resistance this can signal an end to the consolidation and a new outlook has formed.
  2. Trade the breakout of the rectangle. A rectangle is a consolidation, with no decisive trend and often mixed signals. However, the breakout of a rectangle can generate a more decisive direction. This can generate implied targets and trading levels (see below).

A warning: always look for confirmation

It is important to not trade for a completed rectangle until the move has been confirmed. A rectangle could easily end up becoming a top or base pattern.

Using other indicators, such as momentum can indicate the direction of the breakout, but it is always safest to wait for the price to confirm a completed rectangle.

Implied targets, pullbacks and stop-losses

A completed rectangle pattern will generate key trading levels.

The pattern will give us an implied target, an expected potential area for a pullback and a stop-loss where the pattern is considered to have been aborted.

Upside breakImplied targetThe height of the rectangle is measured from the key support to the key resistance. This is projected higher from the breakout above the resistance
 PullbackFollowing the breakout, the old resistance becomes a new basis of support for a pullback.
 Stop-lossA retracement lower, back into the old rectangle and a move below half of the pattern height.
   
Downside breakImplied targetThe depth of the rectangle is measured from the key resistance down to the key support. This is projected lower from the breakdown below the key support.
 PullbackOnce the pattern is complete, the old support of the rectangle becomes new resistance.
 Stop-lossA retracement higher, back into the old rectangle, with a move above half of the pattern depth.

When is a rectangle not a rectangle? When it is a reversal.

The rectangle is considered to be a continuation pattern. Subsequently, if the rectangle formation ends up being a trend reversal then it is not a rectangle at all.

If the market consolidates in a rectangle following an uptrend, only for the market to break down, this would be a top reversal pattern. Similarly, if there is a consolidation rectangle after a downtrend that results in a break higher, this would be a base or bottom reversal pattern.

Essentially, it does not overly matter what the pattern is called. The principle of the implied projection, pullback and stop-loss remains the same:

  • The implied target is still the height of the pattern projected from the breakout.
  • The breakout point is still an area where a pullback can be expected to unwind to.
  • The stop loss is still a move back through more than half of the pattern height.

Therefore, we can say that the opposite of a consolidation rectangle is a top/bottom reversal pattern.

Editor

Richard is an independent market analyst with over 20 years of experience working for brokers in London. Most recently he has worked with Hantec Markets and Infinox, focusing on trading education, ana... Continued

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