The rectangle pattern is a classical technical analysis formation characterized by horizontal lines representing significant support and resistance levels. This pattern illustrates a market in a state of indecision, as prices oscillate between these well-defined boundaries. The rectangle pattern ends when a breakout occurs, signifying a decisive move beyond these levels. Traders have two primary approaches when dealing with rectangles: trading within the pattern by buying near support and selling or shorting near resistance, or waiting for a breakout to occur.
The Rectangle in Classical Technical Analysis
The concept of price patterns, including the rectangle, traces its origins to the pioneers of technical analysis, such as Richard Schabaker, Edwards, and Magee. These patterns were initially developed in a time when traders relied on manual charting techniques and basic moving averages. Unlike modern technical analysis, which leans heavily on indicators, the classical approach asserted that price patterns repeat themselves over time, offering opportunities for trading profit. Geometrical figures, like rectangles, triangles, pennants, and head-and-shoulders formations, were commonly used as the basis for these patterns.
The Rectangle: Supply and Demand in Balance
A rectangle on a price chart represents a situation where supply and demand are in relative equilibrium for an extended period. Prices move within a narrow range, encountering resistance at the top of the rectangle and finding support at the bottom. The rectangle can persist for a considerable time or emerge amid a series of bounded fluctuations. This pattern indicates trader indecision, with both bulls and bears exerting similar influence. It can serve as a reversal pattern, signaling the end of a previous trend, or a continuation pattern, suggesting a temporary pause before the trend resumes. Ultimately, either accumulation or distribution prevails, leading to a breakout or breakdown.
"Significant" Support and Resistance
Understanding the concept of support and resistance is vital when working with rectangle patterns. Support refers to price levels below the current market price, where buying temporarily halts a downtrend. Resistance, conversely, represents price levels above the current market price, where selling temporarily interrupts an uptrend. In the case of rectangles, these support and resistance levels are often significant and repeatedly tested, forming horizontal trendlines.
Trading the Rectangle
Trading a rectangle pattern involves two primary strategies:
Trading within the boundaries: Buying near support and selling (or shorting) near resistance. To manage risk, use a tight stop-loss, usually around 3% below the support level.
Waiting for a breakout: A breakout should ideally occur with above-average trading volume. The measuring principle can help traders set a minimum price target and guide their decision to exit the trade.
The Measuring Principle
The measuring principle allows traders to establish a specific minimum price target. To calculate this target, determine the height of the pattern. For a bullish breakout, add the height to the breakout level. While this target isn't a guarantee, it provides a clear objective for traders to hold during minor countertrend movements. Monitoring the technical picture of the stock remains essential.
Summary
The rectangle pattern is a valuable tool in the toolkit of technical analysts. Its clear depiction of market indecision, along with the well-defined support and resistance levels, makes it a useful pattern for traders. Whether you choose to trade within the pattern's boundaries or wait for a breakout, understanding the rectangle's dynamics can help you make more informed trading decisions. Like the shareholders who traded the rectangle in the case of ImClone Systems, you might find that this pattern can lead to favorable outcomes, turning you "square" in the world of trading.
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