MAILBAG QUESTION:

"you wrote about chart patterns with predictable outcome and quote a study by professor Lo. What about rectangle bottoms as one he mentioned? isn't that what the S&P is breaking out of? And does this suggest a price target"

MY RESPONSE:

The study conducted by Dr. Lo at MIT, also involving some of his grad students helping to crunch the numbers, mentioned the chart formation of a rectangle bottom as one that is predictable (better than a 'chance' outcome) in forming ahead of subsequent upside reversals.

It's true that the S&P, Dow and Nasdaq to a lesser degree have traced out the sideways range-bound trade that may be called a rectangle in technical analysis terms. I'll highlight this pattern in the S&P 500 (SPX) on the daily and hourly charts.

After a prolonged earlier advance, a sideways price trend where prices bounce up and down in a relatively narrow price range is assumed (until proven otherwise) to be merely a consolidation of the prior advancing trend. And that a potential breakout is more likely to be ABOVE the top end of the prior sideways trading range.

The foregoing description is a variation of the rectangle pattern. IF there's an upside breakout, above the line of prior (similar) tops, the rectangle is considered to be a continuation pattern; i.e., one that suggests that the prior advance is continuing and that its likely another up leg is underway.

The rectangle bottom that Professor Lo discussed as having some reliability in predicting an upside reversal ahead does have some different characteristics. Namely, that the trend was DOWN before the formation of the sideways trading range of the 'rectangle'. When there's an eventual breakout above the top end of the rectangular trading range, the prior range-bound trade is thought to have traced out a rectangle bottom.

With SPX, the piercing the upper end of its range-bound trade as happened in the week just ending, isn't a bottom pattern per se as SPX's low was put in long ago. Here a rectangle pattern is marking time before there's a continuation of the prior uptrend.

Summing up, a rectangle can end up representing a reversal type pattern OR a continuation pattern. However, the OBJECTIVE implied by the breakout above or below a rectangle is the SAME regardless of whether the pattern turns out to be a rectangle that:

1.) represents a 'continuation' of the prior trend up or down;

2.) a rectangle that forms after a bearish trend, where a breakout above the top end of the rectangle signals a trend reversal up OR

3.) a rectangle that forms after a prolonged run up, where a downside reversal below the bottom of the rectangle trading range suggests the pattern represented a rectangle top.

We mostly know what a rectangle represents, a continuation pattern, a top, or a bottom, in hindsight. Strategy wise, the key is to follow the DIRECTION of the breakout, above or below the rectangle and I want to focus more on implied objectives as useful in plotting price targets.

Time for some chart examples, the first is of the hourly S&P 500 (SPX) with notations of potential upside objectives implied by the breakout above the box-like rectangle pattern.

The more speculative objective is obtained by taking the 'length' of the sideways move and adding it to the breakout point (line 'a'). 'Speculative' because doing this kind of analysis (as done first by WD Gann) is considered most reliable with charts that are 'squared' up; i.e., where one unit of time (the width of 1 horizontal time period or bar) is equal to 1 price point on the vertical price scale. To do this measurement accurately requires a special trading application. I'll call what I did below a 'rule of thumb' I do more or less successfully, especially using matchbook foldouts on the back of cocktail napkins after trading hours.

Looking further into the aforementioned rule of thumb measurement of taking the horizontal distance that equals the duration of the sideways trend and adding this (distance) to the 'breakout' point at the top of the highlighted rectangle as applied to SPX's daily chart is seen next.

The rectangle pattern as a continuation formation prior to a move in the SAME direction as the dominant trend; or, as a bottom formation in a previous downtrend; or, as a top in a previous uptrend is seen on everything from intraday to daily or weekly charts.

The rectangle pattern is more commonly seen on hourly and daily chart time frames, especially in the indexes and in commodities like oil or gold. However, in stocks, rectangle bottoms are sometimes seen on a weekly chart basis. What I first thought was an example below with IBM's weekly chart wasn't particularly what defines the pattern but is another teaching moment I suppose.

I went looking for more of a classic rectangle bottom in a stock that takes place over a multiyear time frame (an 'investment' horizon), which is sometimes seen with big cap stocks.

My last chart is again on a weekly chart basis, this time with Wal-Mart (WMT). (Bottoms in stocks and stock indexes are more commonly V-bottom, with final spike lows.)


GOOD TRADING SUCCESS!