A Comprehensive Guide to Rectangle Formation.

27 Mar 2022

Introduction:
Price trends do not usually reverse on a dime. uptrend and downtrend are typically separated by a transitional period or trading range, and trading range formation signal trading opportunities for traders.

The trading range separating rising and falling price trends discussed here
is a pattern known as a rectangle.

This post will cover these questions:
1. Types of a trend reversal.
2. Rectangle formation.
3. consolidation rectangles.
4. Significance of a rectangle pattern.
5. Retracement moves
6. What when a rectangle fails?

1.Trend reversal

The turning point between the bull and bear phases is termed a reversal pattern.
# Reversal patterns at market tops are known as distribution because the security is said to be “distributed” from strong, informed participants to weak, uninformed ones.

# Price patterns, including rectangles, that develop at market bottoms are
called accumulation formations where the security passes from weak, uninformed participants to strong, informed ones.

a.Horizontal or transitional reversal.

An oil tanker takes a long time to slow down and then go into reverse. The same is normally
true of financial markets. Generally speaking, the longer the trend, the more
time spent in the reversal (turnaround) process. This transitional or horizontal phase has great significance
because it is the demarcation between a rising and a falling trend.

b. Reversal on a dime without warning.

This type of reversal is the exception to transitional reversal and they are the highly emotional market that changes without warning.

2. Rectangle formation.


The figure shows the price action at the end of a long rising trend. price starts to move in a trading range between Point A and Point B.
Point A can be identified as a resistance area after the price backed of two times from Point A.
Point B can be identified as a support area after the price moved up two times from Point B.
one can draw horizontal trendlines or Box on the chart to mark the level.

At this point, the demand/supply relationship comes into balance in favour of the sellers whenever the price
reaches A, and the demand/supply relationship comes into balance in favour of the buyers when the price reaches B.
Finally, prices fall below point B signals a trend reversal and the sellers are dominating the market.

3. consolidation rectangles.
If the rectangle following an uptrend is completed with a victory for the buyers as the price pushes through the upper line A , a reversal does not develop because the breakout above A reaffirms the underlying trend. In this case, the corrective phase (trading range) associated with the formation of the
rectangle temporarily interrupts the bull market and becomes a consolidation pattern.


In the figure, a breakout to the upside makes this pattern a continuation rectangle.

#the prevailing trend is in existence until it is proved to have been reversed.

4. Significance of a rectangle pattern.

i. Time Frames
The longer the time frame, the more significant the pattern. A pattern that
shows up on a monthly chart is likely to be far more significant than one
on an intraday chart, and so forth.

the longer a pattern takes to develop in a particular time frame, the greater its significance within that
time frame.
# Most of the time the larger pattern will be more important, but not every time. In technical analysis, we are dealing in probabilities, never certainties.

ii.Volume Considerations.

volume is an important independent variable that can help us obtain a more accurate reflection of crowd psychology. volume shrinks during the formation of pattern and blastoff on successful breakout/breakdown of the price.

iii. Measuring implications:

The depth of the pattern is projected in the direction of the breakout from the breakout point

5. Retracement moves.

Many times when the price breaks out from the rectangle, the initial move is followed by a corrective move back to the breakout point. This is known as a retracement move, and it offers an additional entry point for left out players who pushes the prices again in the breakout direction.

6. What when a rectangle fails?
One of the first things that should be done upon entering any business venture is to weigh the possible risk against the potential reward. the same is true in the financial markets.

*Amatures on breakout only focuses on potential profits.
*Professionals always consider the risk as an equal.

this means when opening a new position you have to consider the risk to reward ratio and decide prior to opening the position what type of price action would cause you to conclude that the breakout was a whipsaw.

Some price action to consider to identify a whipsaw (fake breakout).

a.50% rule.

It very much depends on the chart. If there are no obvious support points, many traders believe that a penetration of the 50 percent mark is the place to exit. In this case, the 50 percent mark is the central point between the two horizontal lines that make up the rectangle.

b. Trendline support

using price action trendline to identify if the trend is valid or has been breached.

c. Stop below/above the opposite line of breakout/breakdown.
one can set a stop above the resistance line if the short-sell position is triggered.
or set a stop below the support line if the long position is triggered.

d. False breakouts:
Shrinking volume on an upside/downside breakout.

Hope you found this helpful and I sincerely hope you find a ton of good rectangle formations to trade-in!

Happy Trading!