Rectangle Formation

The rectangle pattern goes by several other names. You may recognize it as what Dow called a line. It is just a consolidation period in a trend, whether up or down, and usually ends with a continuation in the original trend direction. It looks like this in an uptrend -

If you have read Nicolas Darvas’ book ‘How I Made $2,000,000 in the Stock Market’, a classic published in 1960, you may recognize that he called this box trading and used this pattern, repeated successively, trading the breakouts as the stock moved from level to level.

You can compare its effect and meaning to that of the symmetrical triangle, except with no approaching apex there is no pressing time limitation for it to be resolved in a breakout. You will normally see a pattern length of one to three months. When a decisive breakout happens, with at least a close outside the rectangle, that completes the pattern.

Although it will normally constitute a continuation pattern, you should keep an eye on the volume of trading for some assurance of this – the with trend moves should have a heavier volume than those that go against the trend. As you may have noticed, the pattern resembles the triple top reversal pattern, and the difference, until made clear by the breakout, is that the volume indications go the opposite way.

While you usually want to trade in and with a trend, when you come across this clear pattern you could take short term positions within the range. You would buy at the lower line and/or sell short at the top. The risks are not great, as you will know straight away if the price breaks out of the pattern, and be able to exit the position and take up an opposing trade. The alternative way to trade the rectangle is to assume, on the basis of probabilities, that it will be a continuation pattern, and take a long position near the lower line, waiting for the breakout for your profits.

It is easy to see price targets for this formation – as the lines are parallel, the distance between them is the amount you can expect the breakout to move, outside the box. With such clear boundaries, the lines work as support and resistance with a reversal in role when violated, as covered previously. For example, in an uptrend, after the breakout the upper line will change from being a resistance to become a solid support line for the higher range.

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