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Trader's Corner

'Rectangle' Chart Patterns (2)

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MEA CULPA
Last week (1/10/07) I wrote the article below about current noteworthy chart formations we had been seeing in the major stock indexes and then proceeded to send the RIGHT charts, but the WRONG article; by mistake I attached my Trader's Corner article from a year ago, which was, how can I say it, totally WRONG!! To make sense of the charts printed LAST week, I'm reprinting the right explanatory text with, first, the charts from last week, FOLLOWED by chart updates through today with an updated comment. I hope this will not confuse...its one snapshot in time, followed by today's chart snapshot for the major indexes, also in time. It's all about the sideways chart pattern called a rectangle, which in the current situation could be a top pattern, in some cases a 'consolidation' formation before another major move in the same direction as previously.

REPRINTING LAST WEEK'S DISCUSSION:
My mail brought a question from an Option Investor subscriber relating to the broad sideways trend in the market (and loss of the prior strong upside momentum) that's been going on since early-December that I've been commenting on in my recent weekend Index Trader columns.

QUESTION: "What do you make of this the sideways trend in the indexes? What does it predict about the future direction of the market, like it being a possible top or whatever."

RESPONSE:
A sideways trend, as seen in the major market indexes in recent weeks, can be seen or defined (more or less) as a 'RECTANGLE' pattern. I make a definition of this in my book (Essential Technical Analysis) as follows; the pattern could form in a stock, stock index or any other market such as oil, Treasury bonds, or the dollar:

"A rectangle is a sideways 'trading range' forming after either an uptrend or downtrend and that most often is a consolidation of the prior trend, before a further move in the same direction as this trend. The name comes from the shape of the pattern, which requires a sideways trend that goes on long enough that the pattern's width is longer than the consolidation trading range is high. Sometimes a rectangle will end up forming a so-called rectangle-top or a rectangle-bottom pattern. The key is the direction of the a breakout move above or below the top or bottom lines drawn across the (trading) range's highs or lows."

There would typically be or should be 2-3 or more highs that form in the same price area, as well as 2-3 or more lows that get made in the same price zone; two lines drawn across these highs and across these lows then define an upper horizontal and a lower horizontal trendline.

This pattern, especially in stocks, classically will have a duration of months (e.g., 6 months), rather than weeks. Some analysts and market observers define TWO types of rectangles: a 'rectangle top' and a 'rectangle bottom'. However, this is for purposes mostly of separating two possibilities: that the pattern could be the formation of a top after a lengthily advance OR the formation of a bottom, after a lengthily decline. However, it should be noted that the rectangle pattern is not associated with a classic definition/prediction that EITHER a top or bottom should follow such a sideways trend. Rather we have to observe in WHICH direction is the next move, above or below the box like pattern.

The following two situations define when a rectangle is a CONSOLIDATION of the prior trend:

1. The market (or stock) has been advancing previously, which is the current situation and this is followed by a series of sideways, back and forth price swings that end in roughly the same areas on the upside and the downside. If the next significant price swing or 'leg' is up, carrying prices decisively ABOVE the top end of the rectangle, the pattern was simply a pause/'consolidation' of the prior advance.

2. The index or stock has been in a significant decline, followed by a series of back and forth price moves that tend to top out and bottom in the same area 2, 3 or more times. If the next significant price swing or 'leg' is BELOW, the 'line' of prior lows, the pause or sideways move (the rectangle) was simply a 'consolidation' of the prior downtrend, before the dominant bear trend continued.

When a rectangle defines a trend REVERSAL pattern is when:

1. The sideways trading range or rectangle pattern, after a prolonged advance, is followed by a breakout to the DOWNSIDE. This pattern then 'becomes' (is defined as) a rectangle-top.

2. The sideways trading range or rectangle pattern (after a prolonged decline) is followed by a breakout to the UPSIDE; the pattern then becomes defined as having been a rectangle-bottom.

A study done at MIT by Dr. Andrew Lo and which I cite in my book found that rectangle tops and rectangle bottoms were two (of 5) chart patterns that they found to be significantly correlated to a predictable outcome; that is, a REVERSAL. So, it seems from the situation that they studied that the pattern was more often a reversal pattern. Time will tell on the indexes and the sideways trading range is not that old yet.

Interestingly, the Nasdaq (Apple mania?) looked like it might break out to the UPSIDE of the sideways trading range that the Nas Composite, and to a lesser extent the Nasdaq 100 (NDX), whereas the S&P is nearer to the low end of the trading range that IT has been in for awhile now, in both the broader 500 (SPX) and the biggest cap 100 (OEX).

THE NASDAQ COMPOSITE (COMP)
With the Composite daily chart below, I outline the possibility that an upside OR a downside breakout could equal the 'classic' objective for a next price swing that is at least equal to the WIDTH of the rectangle. This is a starting point or 'rule of thumb' only. Bulkowski found in his work (Encyclopedia of Chart Patterns) that 'rectangle tops' with UPSIDE breakouts had a further gain of 50% of what had come before, with the average gain equal to between 20 and 30 percent.

CHART AS OF 1/10:

Consistent with the MIT study, Tom Bulkowski found that DOWNSIDE breakouts occurred somewhat more for this pattern; but, once the low end of the range was pierced, the average decline was just 20 percent.

My take on this all and its consistent with MY experience is that when the pattern you see above and below resolves itself to the UPSIDE, the further gain tends to be more than when the index (or stock) declines or breaks to the downside.

Hey, this might be the old saw that a trend in motion tends to STAY in motion. I tend to give the benefit of the doubt, as to which DIRECTION a breakout move will occur as to being in the SAME direction as the prior trend. However, the key to trading this pattern, as in any trading range, is to trade in the DIRECTION of the breakout, certainly not AGAINST it.

UPDATED COMP CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
As we'll see further along, with the inability of the S&P to follow through to the upside, the apparent 'breakout' to the upside as seen in the updated chart could have been a 'false' one. Telling for this, will be whether the Nas Composite now falls back into its prior price range, outlined by the rectangular outline I've drawn on the daily COMP chart here. The 2470 area is key. If the Index stays ABOVE its prior range, COMP has upside potential to the 2550 area. If COMP starts closing under 2470, its back in its 2390-2470 trading range; and with the question of the DIRECTION of the next big move left unresolved from a technical/chart standpoint.

THE NASDAQ 100 (NDX):

FIRST CHART IS AS OF 1/10:
The Nas 100/NDX pattern doesn't have the same 'definition' as the Composite in terms of having 2-3 or more 'touches' to a high in the same approximate area and a number of lows also around the same price zone. If we use a close-only (line) chart and assume that the Closing high to date and the closing low to date 'define' upper and lower ends of the same rectangle pattern we see in COMP, the following outline is projected for NDX, along with potential upside or downside price targets (on a Closing basis):

UPDATED NDX CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
The same updated commentary applied with the Nas 100 below, was also true with the Composite chart above. The prior high Close in NDX, at 1820, may be threatened here. If the breakout is not going to turn into a short-lived and 'false' one, former resistance should 'become' support if NDX did recently begin a new leg higher. If this was not the case and NDX starts sinking under the prior closing high at 1820, look for initial support in the 1790 area, at the 21-day moving average, or around 1775, at the up trendline seen below; these figures are on a CLOSING basis. Which by the way, some portfolio managers really only focus on, as only the close is considered key.

THE S&P 500 (SPX):

FIRST CHART IS AS OF 1/10:
The limited time spent between the highs and lows that I've outlined below, doesn't give us a lot to go on in SPX; whereas, a longer DURATION sideways trading range tracing out a rectangle tends to becomes more and more significant. The upside or downside potential for a breakout move in either direction based on what we've seen to date (1/10) in SPX however, is presented next:

The SPX pattern above also looks a bit like it could be a rounding top, even an approximate double top.

UPDATED SPX CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
The key aspect of the chart pattern being traced out in the S&P 500 here is that this major index remains basically within its trading range of recent weeks being traced out between the low-1400s and 1432/1435. This type rectangle pattern could be tracing out what will be seen later as a RECTANGLE-TOP. Time will tell and what will be telling is the DIRECTION of a breakout move.

One anticipated expectation for the S&P is that the Index probably won't continue for a lot more weeks locked in such a narrow price range. However, if it did, that would tell us something also. The LONGER that a major index trends sideways in a box-like trading range/rectangle pattern, the larger or more significant the breakout move tends to be when it does come, whether that's up or down.

THE S&P 100 (OEX):

FIRST CHART, AS OF LAST WEEK'S 1/10 CLOSE:
The OEX sideways trading range of late isn't highly defined in terms of duration, but there is a minimal trading range that has shaped up here in recent weeks. My projection/speculation as the upside or downside potential on a breakout above or below that range, is presented in my last chart. This chart serves as an illustration of the future price projections involving a rectangle, albeit one reflecting a trading range that has not gone on so long as to have great confidence in the upside and downside targets of future price swings. The more defined (i.e., in terms of duration) the trading range of a rectangle pattern, the more likely it is to see big follow through on a breakout above or below that range.

I have seen individual traders getting more excited about tech (hope springs eternal in Nasdaq for that next monster bull market) and it seems that individuals may be driving Nasdaq more, whereas there is some caution by institutional investors and a wait and see attitude here about the S&P stocks ahead of the full spectrum of earnings reports ahead.

UPDATED OEX CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
No surprise here that the S&P 100 is also locked in a narrow trading range still like its cousin index, the S&P 500. The big cap OEX is still tracing out a sideways rectangle and a narrow price range. This is of course the proverbial 'kiss of death' to index option traders who are buying calls and puts as this kind of narrow range mostly only favors those selling premium in calls and puts or otherwise adopting strategies to capture premium based on prices remaining range-bound.

The longer that an index is range-bound like this after such a big advance that came before, the more we should be wary of thinking that this market is never going to top out. The expectation that this market was only going up was getting to be a widespread view. The reality usually signaled by a rectangle or trading side/sideways movement like we're seeing is that buying and selling forces get in balance and we don't know what events and which way or which direction the next large price swing will take. As traders, we need wait for a move and direction of that move, up or down. Even then, there are some occasions when 'false' breakouts come or ones not following through overly much such as in Nasdaq perhaps. Stay tuned on that!


GOOD TRADING SUCCESS!

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