Last Updated on 10 March, 2020 by Therobusttrader
There are many types of price formations in technical analysis that are believed to give useful insights about where the market is headed. One pattern, which is the topic of this article, is the rectangle pattern.
A rectangle is a price formation that occurs when the market grinds to a halt in an ongoing uptrend or downtrend and consolidates sideways for some time. The common interpretation of a rectangle is that the market is going to continue in the direction of the preceding trend, which makes it a sort of continuation pattern.
In this guide to the rectangle trading pattern, we’ll cover everything you need to know. That includes:
- How to identify rectangles
- How most traders go about to trade rectangles
- How to improve the performance of any rectangle pattern
What Does a Rectangle Mean in Trading? – How to Identify a Rectangle
As we touched on briefly, a rectangle pattern is a sort of consolidation pattern that occurs when the price is contained by two support and resistance lines that run in parallel. In essence, it means that the market is taking a short break after having gone up or down for quite some time. Some traders will even say that the market is preparing to break out again, as it consolidates.
In the image above we have made an illustration of a rectangle pattern.
In order to make identification a little easier, you could say that a rectangle needs to meet the following criteria:
- The market must be in a fairly long term or medium-term trend.
- Then we need a consolidation period that consists of several tops and bottoms. It’s important that the tops and bottoms are fairly horizontal to each other. This means that a line that connects bottoms with bottoms or tops with tops should be straight, as the image above shows.
- The last step is that we get a breakout in the direction of the previous trend. This tells us that the market finally has ended its consolidating phase, and is headed for new highs or lows, depending on the previous trend.
Bullish and Bearish Rectangles
Rectangles are divided into two groups, which are bullish and bearish rectangles.
A bullish rectangle is when the market is in a bullish trend that turns into a consolidation. As soon as the bullish and bearish forces of the market have played out, bulls come out on top and manage to make prices break out to the upside.
In the image below you see an illustration of the bullish rectangle:
A bearish rectangle is when the market comes from a bearish trend that turns into a consolidation, which then results in a breakdown below the low of the consolidation range.
Below is an example of a bearish rectangle.
What Is the Psychology Behind the Rectangle Pattern?
One of the core assumptions that traders make when they regard the rectangle pattern as a continuation pattern, is that trends don’t go straight from point A to point B. In other words, the trend will not consist only of periods when the market advances or declines in the direction of the main trend, but also of pullbacks and consolidations.
This, in turn, has to do with the aggregate psychology of all market players and how it affects prices. Let’s look at how market psychology might help to form the rectangle pattern.
- As the market is in a bullish trend, market sentiment is positive, and market participants are fairly positive about the outlooks.
- However, since the market has been in an uptrend for quite some time, more and more market participants are starting to think that now may be the right time to take profit. As such, they sell their positions, which prevents the market from rising.
- The coming days and weeks, buying and selling pressure remains equally strong at large, with some days being more positive or negative than others. In short, you could say that market players disagree about whether the security is worth buying or selling. This creates the equilibrium that makes the market respect the previous support and resistance levels.
- At last, buyers take the lead and push prices above the high of the trading range. Now we have got a sign that buyers are ready to pay higher prices, and that supply is decreasing. In other words, it’s all set for a bullish rally to new heights!
While the explanation above might not be completely true, the scenario it depicts serves well as inspiration and to help you understand how and why the markets move. That’s exactly what we need to do as traders, in order to expand our knowledge and understanding of the markets!
How to Trade the Rectangle Pattern:
So, now that we have had a look at bullish and bearish rectangles, it’s time to get a little deeper into how many traders decide to trade the pattern.
Just remember that this approach isn’t guaranteed to work just because a lot of people rely on it. We always recommend that you resort to backtesting to ensure that the concepts you choose to trade work well!
With that said, let’s begin!
1. Spotting the Rectangle
The first step is to spot the rectangle pattern as we explained earlier in the article. This includes the preceding trend and a consolidation that’s contained by support and resistance lines.
Now, as to the length and structure of the consolidation, most traders will demand that you have at least two clear tops and bottoms. If there are more, it helps to further strengthen the support and resistance levels, which makes it more likely that the market will continue to be range-bound for some time to come.
2. The Breakout
The next step is to watch the breakout above the high of the pattern, provided that we’re dealing with a bullish rectangle. The longer the rectangle has been in place and the more times the upper and lower levels have been touched and held up, the harder it gets for the price to overcome the upper level. As a result, when it finally manages to break out above the high, you often see that the reaction is much more fierce and rapid.
Now, while many might be tempted to just trade the breakout as it occurs, others will wait for the price to return to the breakout level in order to see if it holds up or not. If it does, they will go long, but if the price falls back under the breakout level it signals underlying weakness which makes us not want to enter the market.
False breakouts constitute a serious issue for everyone who attempts to trade any sort of breakouts. The approach of waiting for a retest of the breakout level is just one of many things you can do to reduce the chances of acting on false breakouts. Later in the article, we’ll look at some more common methods that are used to combat so-called “fakeouts”.
If you decide to enter a trade once the market breaks above the high of the trading range, you also have to decide when to exit the trade.
Many traders choose to use a stop loss and a profit target, which means that they either exit the trade at a loss or a profit. The placement of the profit target is facilitated by the fact that a rectangle has a target level that’s placed at the same distance from the breakout level as the width of the price channel. The image below illustrates this nicely.
The stop loss may then be placed slightly below the breakout level, so that it will be triggered only if the market reverses and falls down into the rectangle area.
What happens if there is a breakout in the other direction?
No trading pattern or technique works all the time, and the rectangle is no exception. What appears to be a bullish rectangle may very well end in a bearish breakout to the downside. This is why it’s important to monitor the breakout level and enure to get out of the trade if it doesn’t hold upon a revisit to those levels!
The image below shows a failed rectangle pattern. Notice how the market revisits the lower breakout level after the breakout, and then turns down again!
How to Improve the Performance of the Rectangle Pattern
Having covered how you could go about to trade the pattern, we now wanted to share some common techniques that traders use to find out more clues about whether a rectangle pattern is likely to end in a continuation of the trend, or a reversal of the trend.
Let’s look at them one by one!
By including volume in our analysis, we get a better sense of the strength behind the actual market moves, which might otherwise escape our attention.
When trading rectangles, we want to see that the volume of the market is increasing as the consolidation goes on . This tells us that market activity is catching up, which often is a great sign that the market will continue in the direction of the preceding trend.
To better visualize the changes in volume levels in the market, it’s common to apply a moving average to the volume readings. In the image below you see a rectangle pattern where the volume increases as the pattern grows older.
2. The Length of the Preceding Trend
Another key aspect that should not be forgotten, is the length of the trend that precedes the rectangle. With long trends that have formed during many years, there is a lot of stiffness built into the market. Market participants are used to seeing the market continue in the direction of the prevailing trend, and most times, the fundamental data has supported the trend for a long time, and continues to do so.
In these cases, we may find it much more likely that a rectangle does end as a continuation pattern. We simply have the long term trend that pushes the market in the direction of the impending breakout.
This behavior is especially pronounced in the stock market, where we have a long term rising trend that is backed by fundamental data, and won’t end anytime soon!
Gaps occur when a bar closes higher or lower than the close of the previous bar, and signal that there is a lot of volatility in the market.
In the case of the rectangle pattern, a lot of gaps occurring around the breakout level and when the market breaks out could be a good indication that the move is worth acting on. For instance, if we’re watching a breakout from a bullish rectangle and there is a lot of positive gaps, it tells us that the market sentiment is quite bullish overall.
The image we presented under point one actually shows a huge gap that forms as part of the breakout, so here it comes one more time!
Rectangles VS Flags
If you have heard about the flag pattern, you might recognize that the rectangle pattern many times resembles the flag pattern very closely.
This observation is correct, and both patterns are very similar. Sometimes two traders may even say that they are the same.
However, if you were to point out the main difference, it lies in that a flag is a short term pattern that forms during a period of less than a week, while a rectangle may take several weeks or even months to form!
In this guide to rectangles in trading, we’ve had a look at what the pattern is, and what it tells us about the market. In addition, you’ve learned how you could go about to improve the performance of most rectangles and avoid false breakouts, to increase profits.
As a final note, we urge you to not take the concepts and methods presented as the final truth. Markets evolve all the time, and there is no guarantee that what you believe about the markets actually works that well.
The best way to avoid trading losing ideas and systems, therefore, is to start testing the strategies and ideas yourself to see if they hold any merit. This is best done with the help of backtesting, which you may learn more about in our guide to backtesting, or article on how to build a trading strategy.