Shabbir Kayyumi Narnolia Financial Advisors
Basics of Technical Analysis: Part 16
The rectangle is a classical technical analysis pattern described by horizontal lines showing significant support and resistance. Rather than modern technical analysis, which relies on indicators, such as moving average convergence divergence (MACD) or Relative strength Index (RSI), many technical analysts assumed that price patterns repeat themselves over the time and are more reliable than indicators.
What is ‘Rectangle’ Pattern?
A rectangle is a chart pattern formed when price are bounded by parallel support and resistance levels. This pattern is where supply and demand are in approximate balance for an extended period of time.In any case, it is a pattern which shows traders indecision, one in which the bulls and bears are approximately equally powerful.
Many of the price patterns are based on geometrical figures, some of them are ascending, descending and symmetrical triangles, pennants and wedges and rectangle.
Rectangles are sometimes referred to as: -
• Trading ranges
• Consolidation zones
• Congestion areas
• Sideways movement
Calculations of target and stop loss
Formation of Rectangle Pattern
•> The rectangle formation mirrors a degree of insecurity among investors, where buyers and sellers are pushing the stock price sideways. When the stock breaks through former tops or bottoms, this indicates expectations for the direction to come and gives good trading opportunities.
•> The rectangle figure is a trading pattern which can appear during bullish and bearish trends. The pattern consists of tops and bottoms, which are parallel to one another.
•> At least two equivalent reaction highs are required to form the upper resistance line and two equivalent reaction lows to form the lower support line.
•> The price will try to breach the support and resistance levels several times before eventually breaking out.
•> For a breakout to be considered validit should be on a closing basis; howeversome traders apply a filter to price (2%) while considering breakout.
Types of Rectangle Pattern
Horizontal lines drawn on the chart denote significant support and resistance, however depending on existing trend we have majorly two types of pattern. These formations are regular, find detail explanation below.
1) Bullish Rectangle Pattern
The bullish rectangle is a continuation pattern that develops during a strong uptrend.Bullish rectangles are useful while buy and hold trading strategies.
We have shown illustration of bullish rectangle pattern of SENSEX bench market index; however after a breakout it has continued its original strong uptrend as indicated below.
2) Bearish Rectangle Pattern
The bearish rectangle is a continuation pattern that develops during a strong downtrend. Bearish rectangles are useful while short and cover trading strategies. The bearish rectangular pattern is the mirror image of the bullish pattern.
We have shown illustration of bearish rectangle pattern of Nifty 50 bench market index; however after a break down it has continued its original strong downtrend and achieved its target as indicated below.
Trading the Rectangle Pattern
1> Buy at support horizontal line and sell at resistance horizontal line.
2> Trade the breakout; buy above breakout point and short sell below break down point. As with all technical patterns, this breakout of rectangle should ideally occur on above-normal volume.
Volume and Rectangle Pattern
Volume can also add further insight while trading these patterns.Volume is invaluable when confirming any of the two types of rectangle pattern break out to upside or downside. If volume isn’t present alongside patterns breakouts, then the resulting trading signal isn’t that reliable.
It is observed that false or fake breakout of pattern is witnessed in absent of volume while pattern completion. Nevertheless observing volume, price action and indicators while breakout of rectangle, will keep trader away from false break outs.
Conclusion
•> The rectangle formation is a typical example of a "price pattern" in technical analysis.
•> A Rectangle is a continuation pattern that forms as a trading range during a pause in the existing strong trend.
•> The pattern can be traded by buying at support and selling at resistance or buying the breakout& selling at break down.
•> The pattern has completed when price breaks out in the direction of the prevailing trend, at which point it will likely continue in this direction.
Disclaimer: The author is Head - Technical & Derivative Research at Narnolia Financial Advisors. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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