After reading my Saturday (12/12/09) Index Wrap
column, where I pinned a very big upside potential as an outcome of the current sideways trading range, someone wrote asking if that was the ONLY outcome I project for what lies ahead for the market. Ah, busted again. I was being overly simplistic and this person knew it! I hate it when people have read many of my Trader's Corner columns over the years, read my book and others, has their own depth of experience and so on; enough to know when I should make a fuller explanation of a technical pattern(s). [kidding!]
A rectangle pattern in chart/technical analysis is one that is without a classic definition of whether the formation is suggesting a reversal pattern OR is a continuation pattern; i.e., implying that the prevailing trend will continue after a pause. The rectangle pattern is where prices trend up OR down repeatedly to recurring price levels (a chart example follows), then oscillate between 2 horizontal trendlines before breaking out EITHER to the upside OR to the downside.
There should be at least TWO touches at or near the same price areas to form upper and lower trendlines. These touches need not alternate, but there should be at least two clearly defined minor highs and two minor lows coming close to or touching the resulting trendlines.
Here comes the slightly confusing part: most rectangle patterns act as consolidations of the existing or prior trend. However, if a stock or index is trending strongly higher and a sideways movement ensues that meets the criteria of a 'rectangle', some traders will assume that the pattern is a TOP; i.e., a reversal type pattern. And the thing is, this is sometimes true.
Conversely, if a stock or index is trending strongly down and a sideways movement develops that meets the criteria of a rectangle, some traders will assume that the resulting pattern is a BOTTOM formation.
The key to this pattern is to follow or trade in the DIRECTION of the breakout, whether it's up or down. I generally assume that the existing trend will rule so to speak and the breakout will be in the direction of the prevailing trend. However, I'm also alert to a possible reversal of the dominant trend, whether that is a major reversal or just a short (2-3 days) to intermediate term (2-3 weeks) affair.
As I started out saying, there is also a measuring implication for a next objective or price target after a breakout above/below a rectangle and here in lies probably the greatest value to planning trading strategy.
Enough words, time for that picture that's worth a thousand of them. Rectangles, especially when a trend is only a few weeks or months old, are most often simply pauses or consolidations of the prior move. Two recent chart examples, one of the S&P 500 (SPX) and the other of Apple Computer (AAPL) shown next represent rectangles that turned out to be consolidations of the existing UPtrend, per the bull market we're in.
I noted in the chart above that if the breakout had instead been to the downside, the 'same' measuring technique would apply as it would for an upside price objective. The next chart will highlight what those (there are two) measuring implications are. Both AAPL and the Nasdaq Tracking Stock (QQQQ) turned out to have rectangles that were reversal type patterns. The rectangle represented a price zone where buying and selling finally got into balance. Eventually, this led to an ascendancy of buying forces and an emerging uptrend.
My focus here is not so much here on the fact that the rectangle was a rectangle bottom, but what were the upside objectives that could be calculated or anticipated once the breakouts above the upper level lines occurred. See the chart for examples of how a 'minimum' objective consisted of taking the range defined by the box (the rectangle) and ADDING to the upper level line, once prices achieved a decisive upside penetration of that line.
There is a further, more 'speculative' target that involves measuring the WIDTH of the rectangle and taking the same as a LENGTH measurement to add to the top of the box as a further breakout objective. This gives a much higher price target as you can see. 'Maximum' is a bit of a misnomer, as of course the eventual move can be anything beyond that. It IS the maximum projection in terms of THIS measuring tool.
The reason that the foregoing is 'speculative' as I noted, is that you will get different upside targets depending on the chart scaling used. You can 'spread out' or condense the bars on a chart. If spread out, the width of the box will increase and the upside projection will as well.
This measuring technique where width of the move equals 'height' of the next, is a Gann method, but he (W.D.Gann) and his adherents have tended to make exclusive use of special scaling techniques (involving special paper or charting software) such that 1 'unit' on the horizontal "time" scale will have the same distance as 1 'unit' or increment of price on the vertical scale.
Nevertheless, the technique of looking at the width of the rectangle to project the height of the next move can provide a useful ballpark target for a 'maximum' upside or downside objective. As you can see above and below, in the case of the reversal type rectangle bottom and the rectangle top, such so-called maximum objectives were met.
COULD GO UP, COULD GO DOWN
My current chart prognostications for the major indexes is that I assume that the multiweek sideways trend and resulting chart rectangle formation will turn out to be a pause or consolidation of the prior bull trend and that the next leg will be up. However, I've noted on the S&P 500 (SPX) chart that follows a projection for a next price swing that is up and for a downswing as well. A 'minimum' upside target on a breakout is to 1147, a minimum objective on a downside breakout is to 1054.
The width of the rectangle or the time to completion of the current sideways trend is in flux. However, if there was a decisive upside OR downside penetration of the SPX rectangle in the near-term, a possible maximum target works out to around 1200 on the upside and to around 1000 on the downside. I'm thinking 1200/1200+. I'd also have to say that the jury is still out as to a next big move. While I like directional plays more than strategies dependant on a trading range, any who banked on the recent weeks' range are probably happy.
The Nasdaq 100 (NDX) presents a "could be a top, could be a consolidation" puzzle. The low end of the rectangle is defined by two downswing lows that were only close to the two lowest lows (in the center), but the rectangle is there, with adequate 'definition' of the lower trendline below.
With NDX, 1880 is a possible next objective on an upside breakout above 1815 or the top of the rectangle and 1685 as a possible downside target if 1750 was pierced at the lower line. I don't envision the index breaking out to the downside but future chart action will provide a conclusive outcome.
GOOD TRADING SUCCESS!