One way of looking at the chart patterns being traced out in the S&P and in Nasdaq, is that of possible rectangle bottoms. Potential upside breakouts are near, but yet to happen.

From my Saturday 10/8/11 Index Wrap: "The 'rectangle' formation in stock indexes OR in individual stocks isn't thought of as having a most-typical outcome as a top OR bottom; unlike say a Head & Shoulder's bottom. Technical analyst types and technically oriented traders tend to assume that if the preceding trend has been DOWN, a rectangle pattern suggests a bottom, but the key is a breakout above OR below such a well-defined trading range.

In a study of this pattern in stocks (more patterns to study that way), if the breakout was to the upside, the most likely added rise was around 20%. If the breakout was to the downside, the most likely decline was a further 10-15%."

There are bottom and top patterns that take lengthily periods to form as in trends that start going sideways. Often, in that sideways move, prices will hit the same approximate highs and lows 2-3 or more times. A horizontal line can then be drawn through the tops or bottoms that are the stopping points for 2-3 or more upswings and 2-3 or more downswings. This pattern then forms a so-called 'rectangle'.

Back and forth price swings after a strong advance or decline is most often a continuation type pattern; i.e., prices are marking time or 'consolidating' BEFORE continuing in the same trend direction. In other instances, there's a substantial pullback in a bullish up trend or strong rebound in a bearish down trend and then the sideways move comes. This pattern can be a dynamic occurring BEFORE the major long-term trend continues; e.g., in the current market this would be a breakout to the upside as the long-term trend is (still) UP. However, whether there is an upside OR downside breakout in a rectangle pattern, the trade strategy that looks promising is to trade in the DIRECTION of the breakout.

A rectangle is something Charles Dow called a line formation. A 'rectangle' has to be imagined, or actually drawn, by two horizontal lines connecting a series of similar highs and similar lows, creating a sideways trading range formation that 'interrupts' an advancing or declining trend. The sideways move or 'rectangle' most often occurs prior to the resumption of the dominant trend. The caveat to this, is that in some instances the rectangle suggests formation of a secondary top or bottom and becomes the prelude to a longer-term trend reversal.

Since this pattern has been studied most extensively in individual stock charts, I'll start with one Nasdaq bellwether stock (AAPL) that already formed a rectangle bottom AND met the 'minimum' implied upside objective for this formation.

MEASURING IMPLICATIONS: RECTANGLE TOPS and BOTTOMS

After a breakout to the upside from a rectangle bottom, the minimum objective for a next price target is the price distance between the highs and lows ADDED to the upper line. After a breakout to the downside from a rectangle top, the minimum objective for a next price target is the price distance between the highs and lows SUBTRACTED from the lower line.

Any 'minimum' upside or downside objective is only that. Minimums of course might NOT be realized or quite realized. Often minimum price objectives will be exceeded, sometimes dramatically so. Also, in general the LONGER the sideways trend, there's a tendency for there to be a stronger/longer resulting breakout move above or below the top/bottom of the rectangle.

There's another sort of 'rule of thumb', back of a cocktail napkin, way of measuring the extent of Apple's upside objective seen above. This is to measure the WIDTH of the rectangle pattern and add that distance to the top end of the box. In this instance, that produced an objective to 420. As prescient as this might have been, there's the problem of 'scaling' here. If I zoom in on the pattern it makes the rectangle WIDER. The more I do this, the higher my potential 'breakout' objective.

Unless you are using a 1 X 1 scaling, where one 'unit' of time (horizontal scale) is equal to one 'unit' of price (vertical scale) as is used in a Gann charting application, this kind of objective is hit or miss as to future accuracy.

Of course, there's nothing that says measuring the vertical distance of the box and adding this to the top end of the trading range (the rectangle) produces an 'objective' result, but its closer to what happens in many instance of this formation and is in effect a 'measured move' objective; i.e., a move up or down of X amount tends to REPEAT itself in a subsequent move in the SAME direction.

My two next charts are stocks that are part of the S&P 500 (SPX). One that has ALREADY broken out to the upside (XOM) after tracing out this pattern; and one bellwether S&P stock, GE, that could be on the verge of doing so, but hasn't yet, just like the S&P 500 Index itself.


STOCK INDEXES WITH POSSIBLE RECTANGLE BOTTOM PATTERNS

I haven't done an upside calculation for the S&P 500, (shown next) ASSUMING SPX achieves a decisive upside penetration of 1225, the current high end of the Index's trading range and the top end of the rectangular formation highlighted on my chart.

It's simple enough for all to calculate. You'll likely note that there was one spike low that carried SPX to below 1100, yet I highlight this level as the LOW end of the rectangle. It's sometimes necessary to use the predominate low, where 2 or more bottoms were made, to judge where the low end of a trading range mostly occurred; as opposed to the push to a panic type low or excitement type intraday top.

The predominate price range involved with SPX was 1225 at the high end of the rectangle and 1100 on the low end, for a price range of 125 points. If SPX achieves a sustained push above 1225, look for a potential objective to around 1350 (1225 + 125), which would represent an eventual move back to the area of the summer highs. Stay tuned on that!

Assuming that the Nas Composite (COMP) can push higher in a SUSTAINED move above the 2618-2630 area and it was turned back lower today from this area today, the same calculation as discussed in my other examples would apply as to a potential (minimal) upside objective; e.g., 2618 minus 2327 added to the top end of the rectangular boxlike pattern for a potential objective to around 2900, plus or minus 30 points. This rule of thumb calculation suggests that COMP might eventually challenge its May and July highs.

IF THERE'S A DECISIVE UPSIDE BREAKOUT ABOVE THE TOP END OF THE RECTANGLE, AS SEEN WITH GE, SPX AND COMP, IT'S A LIKELY 'RECTANGLE BOTTOM'. OTHERWISE IT'S SIMPLY A TRADING RANGE MARKET THAT CAN GO ON FOR A CONTINUED PERIOD.

As is always true for any minimum price objective rule of thumb, such rules are useful for an initial objective at the time of the breakout. After the trend develops, you need to follow the trend developments and also use other technical analysis analytical tools (e.g., trendlines), in order to see just how the price trend may extend in terms of duration and price.

I mention in my (Essential Technical Analysis) book about past studies done by Dr. Andrew Lo at MIT as to whether technical price 'patterns' had future predictive value. Among the 5 he found that did, were so-called rectangle tops and rectangle bottoms, which makes for 2 of the 5 chart patterns found significantly correlated to the expected outcome.

If a rectangle forms after an advance, but the breakout is downward and the following price trend continues lower, it is considered to be a rectangle TOP. Conversely, if a rectangle formed after a decline and the direction of the breakout is UP, this becomes a rectangle BOTTOM and both become reversal type patterns.


GOOD TRADING SUCCESS!