Option Investor
Trader's Corner

Rectangle Patterns: Tops and Bottoms

HAVING TROUBLE PRINTING?
Printer friendly version

Now that the S&P and Dow have been in sideways trends for some weeks, making at least two tops in the same area and two bottoms in the same area, the pattern being traced out is called in technical or chart analysis terms a 'rectangle'. Chart patterns are commonly divided into consolidation or reversal patterns.

For example, a Head & Shoulder's top or bottom usually suggests that a reversal of the current dominant trend lies ahead. A sideways movement or trend, which might be of short duration (a few days) like a 'flag' pattern is one where prices could be said to 'consolidate' the prior gains or prior decline, before taking off again in the direction of the dominant prior trend, either up or down.

The rectangle is a hybrid pattern so to speak, and is simply where prices hit the same high 2-3 or more times and the same lows 2-3 or more times.

A long sideways move, coming after a substantial decline OR a substantial decline may be a consolidation of the existing trend before prices continue in the same direction as before. Take the example of a strong advance in a stock on favorable news and earnings or earnings prospects. The stock takes off on a run from $10 to $30. Volume is brisk, there are many buyers and sellers are few. The stock levels off around $30 and some profit taking ensues and the stock dips to $25. Buyers who didn't get in on the run to $30 step in and the stock rallies to $30 again. Some more selling comes and potential buyers take a wait and see attitude to see if the stock can or will pierce 30. Another dip occurs and the stock dips to around 25 again and then rallies to somewhere within that 5 point range.

There are three possibilities next:
#1) The stock settles into a $25 30 trading range for weeks. But stocks will tend to start trending up or down again at some point.
#2) The stock breaks out above $30 and runs to $40. The sideways or lateral movement was a consolidation, prior to a resumption of the uptrend.
#3) The stock falls under $25 and eventually drops to $15. The sideways trend was a rectangle top because the direction of the trend BEFORE the sideways move was UP and the low end of the rectangle (2-3 or more lows made in the same area) was pierced to the DOWNSIDE.

The reverse is true. A decline followed by a sideways trend tracing out a rectangular pattern of multiple highs in the same area and multiple lows in the same area may turn out to be a rectangle bottom. The key is the DIRECTION of the breakout. If there's breakout above the 'line' of prior highs, there may be a prolonged and strong move higher. Charles Dow in fact used to call this type pattern a 'line' formation. If there is an extension of the decline and the breakout is to the downside, this tells us something also: don't stick around and stay long as there may another good-sized downswing. However, it's also true that sometimes this is the last decline before an upside reversal.

The same is true of a rectangle or sideways move that traces out what you think is a rectangle top: sometimes there is an apparent breakout above the line of prior highs as stops are run but then a downside reversal ensues. If a reversal, the key development is whether the line of prior highs gives way; resistance, once broken, should provide a new level of support. There was such a good example of this today as to where buying interest or support came in on the Nasdaq Composite: at the level or the line of the prior highs as seen in the COMP chart below. Whether this rebound continues or not, it's hard to say, but the first line of support was fairly predictable.

But I was speaking of the RECTANGLE pattern. How quickly inquiring minds get diverted! The definition of a 'rectangle' is a pause in the direction of a definite trend. The trend pause is where a stock or index makes a counter-trend retracement of the prior move. This lasts until the stock or index resumes its prior trend. This is followed by more price reversals; the resulting up and down, back and forth trend traces out 2-3 or more tops in the same area and 2-3 or more lows in the same, or close to the same area. TWO HORIZONTAL trendlines can then be drawn, one across the highs and one across lows made in the same area.

What makes a rectangle pattern a POSSIBLE top or a possible bottom is somewhat open to debate. Some analysts say that you simple trade in the direction of the breakout. Others, such as Tom Bulkowski, the author of The Encyclopedia of Chart Patterns, makes an assumption that whether a rectangle is a top or a bottom is based on the price trend approaching the chart pattern (i.e., the rectangle).

If the trend is downward, then the rectangle formation that forms is tracing out a bottom. If the trend is up, then the rectangle formation that forms is likely to be a rectangle top. This reasoning makes the assumption that a lengthy rectangular type sideways or lateral trend AFTER a prolonged advance is tracing out a TOP. Conversely, a lengthy rectangular type sideways or lateral trend AFTER a prolonged decline is tracing out a BOTTOM.

The foregoing would suggest the pattern we are seeing in the S&P and Dow could be a rectangle top. But no one can be sure of this. Obviously we're in a current struggle between the haves and have-nots so to speak. Those that own stock, but may want to sell some, have identified a level in terms of the S&P and/or Dow at which they are willing to raise some cash. When it gets to this area, they sell, forcing stock prices lower. When prices fall back, particularly to the low end of the recent price range, they stop selling.

On the other side is another group of investors, traders and money managers who are willing to acquire more stock at a level where they perceive value or fair value. When the S&P or Dow falls to a level where value is perceived, their buy orders overwhelm supply and the indexes rises.

A RECTANGLE BOTTOM

The price of Apple's (AAPL) stock was falling steadily into early 2003. The stock then went into a sideways trend, which over time in its back and forth price action traced out what is characteristic of rectangle and probably a rectangle bottom. There was one further DOWNSIDE breakout in April of that year on heavy volume; typical of a downside selling 'climax'. The lower line of the rectangle was decisively penetrated at the green up arrow. There was an approximate further 9% decline in the stock. This is consistent with Bulkowski's studies of stocks where the average decline on a downside break of an assumed rectangle bottom was a further 10 to 15 percent.

After the heavy volume sell off that occurred on the downswing below the lower line seen below, volume subsided, suggesting that those that were going to sell had done so. The rebound back above the lower line, what should have then have 'become' resistance, was the tip off that the stock had completed it's bottoming process. The sharp upside breakout above the UPPER end of the rectangle was the confirming 'signal' to buy the stock. Hey, don't you wish you owned Apple at 7.60? Terrible to contemplate, having to pay ALL those capital gains (15%) when you do sell!

POSSIBLE RECTANGLE TOPS

The patterns that have been traced out in the S&P and the Dow could, as I noted, be forming rectangle tops. I don't know that we are seeing the formation of a top in the market here as the next breakout can be to the upside and suggest that the sideways rectangle was a consolidation of the prior trend rather than setting up a reversal pattern. We judge outcome by whether the next price swing takes prices above or below the horizontal lines of the rectangle.

Some analysts would lean to a bearish top building interpretation of a rectangle top for what we seen in S&P and Dow charts. My focus is more on trading tactics and to look at price projections based on similar past patterns in terms of measuring the price swing that follows an upside or downside breakout.

The 'measuring implication' is to calculate the height of the rectangle from (horizontal) trendline to trendline. For upside breakouts where prices pierce the upper line and keep going, add the height to the top trendline; for downside breakouts, subtract this distance from the bottom trendline. The result is the 'minimum' expected move. For a 'maximum' price target add the LENGTH left to right of the rectangle and extend it vertically above the top trendline (for upside breakouts) or below the bottom one (for downside breakouts); that price becomes a 'maximum' expected move.

This later rule of thumb is based on the analysis of WD Gann and is a bit more speculative as the time and price scales should be equal for this projection to be most accurate. However, it is a good rule of thumb to give some idea about where an index or stock COULD get to.

The minimum upside projection for the S&P 100 (OEX), seen below, assuming a decisive upside penetration of 707, is to 730 (707 684 = 23 707 = 730. The maximum upside projection, assuming an upside breakout, is to approximately 780 currently. Since we cannot be sure in which direction a break out will go, it's almost necessary (to be sure) to wait for a close above or below the upper or lower trendline. It's hard to say whether you can trust an intraday move just above or just below the line. This is where I will look for a strong or decisive such move if I want to be in a stock or index option before the close.

Continuing the above example, assuming that this pattern seen in the OEX above is a rectangle top and a downside breakout BELOW 684 occurs, especially on a closing basis, the minimum projected rule-of-thumb objective is to the 660 area: 707 684 = 23; 684 23 = 661.

The maximum downside objective based on subtracting the length of the rectangle and extending that below the lower line is to approximately 630 based on the current length (left to right) of the rectangle. That amount would represent a decline back to area of the early-March low. It seems to be a pretty far away projection at the moment.

Lastly, as far as trading strategies go, if the rectangle is 'tall' enough, buy puts, sell stock or short near the top trendline and buy calls, buy or cover shorts near the bottom trendline.

ONE MORE IN SILENCE


** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for my answer or feedback to Click here to email Leigh Stevens support@optioninvestor.com with my name ('Leigh Stevens') in the Subject line.

GOOD TRADING SUCCESS!
 

Trader's Corner Archives