HOW TO TRADE RECTANGLESAs we already know, a price trend does not usually reverse instantly. As a rule, upward and downward trends are separated by periods when the price is in a trading range - a sideways trend. To take a simple analogy, imagine a huge ship. It's not easy to slow it down, it takes a lot of time. Now imagine how long it takes to turn around? It's the same with prices. Hence the simple rule that the longer the trend is, the more time it takes for it to reverse.
In this case, the process of reversal, aka the horizontal phase of the market is of great importance. Because it is the horizontal range that separates an upward trend from a downward trend (or vice versa). But when the sideways range comes in the shifting phase, the battle between sellers and buyers is equal. Until, for one reason or another, the price does not go down under selling pressure.
It is the breakout of the sideways range, with a new low being reached, that indicates to the trader that a trend reversal is taking place. In other words, when the price falls out of the trading range, it is a sell signal. When the bearish trend ends, the reversal process begins.
The Reversal Rectangle And The Psychology Behind It
When the rectangle is just starting to form, some news is released on the asset and uninformed market participants, who heard about it for the first time, jump in to buy. At this stage, there are positive forecasts everywhere and to go long seems to be the right choice.
We remember that absolutely every trade has two participants: the seller and the buyer. At the same time sellers have absolutely different view on the market. They diligently bought much earlier, on rumors of positive news. And now the positive news has arrived, which means what? That's right, it's time to sell. And who is the best person to sell to? Uninformed participants. This is how the well-known principle "buy the rumors, sell the facts" looks to everyone.
If price patterns like a rectangle are formed at the bottom of the market, they are called accumulative, and the process itself is called accumulation. Here the psychology is exactly the opposite. Sellers see that the price of the asset is falling and decide to sell when bad news and future forecasts become known to all investors. Potential buyers previously hesitated because they did not want to enter on such bad news.
Simply put, the upper reversal rectangle is just a version of the signal that the series of rising highs and lows will reverse. And exactly the opposite is true for the bottom rectangle. You also need to realize that a reversal pattern needs something to reverse. In other words, there should be a clear trend in the opposite direction from the expected reversal before such a rectangle. Accordingly, there should be a strong upward trend up to the top rectangle, and a downward trend down to the bottom rectangle.
How Is The Rectangle Formed?
In the picture shown above, the upper and lower boundaries of the rectangle are formed by at least 3 touches between two horizontal trend lines. However, the rectangle could actually be made on the first two touches. Don't forget, any sideways trend is just an area where buyers and sellers are fighting. If the battle results in a rectangle with more than two touches, it means that the battle between the two sides has turned intense. It also means that the bearish characteristics of the rectangle in the example above are intensifying.
The more touches the rectangle has, the more significant it is
As you will notice we use the phrases "touches" and "approaches" this is important because on real charts rectangles will not be so perfect and beautiful. Approaching any trend line , including the horizontal one in a rectangle, is as important as actually touching it. So, if the price reaches the boundary and then reverses, it reinforces this support or resistance zone anyway.
Significance Of Any Price Pattern
The principles of price patterns are universal. They can be used on any timeframe, from 1-minute candles to monthly candles. However, it is the size and depth of the pattern that influence how significant it is in a particular timeframe.
1. Timeframe
The larger the timeframe, the more significant the pattern is
If a pattern is drawn on a monthly chart, it means that it is significantly more important than the one seen on an intraday chart. Suppose we are looking at a daily chart and we have noticed two patterns. The first one took 10 days to form, while the second one took 4 weeks. It is understandable that the significance of a 4-week epic battle between buyers and sellers is much higher than a 10-day clash.
2. Significance of price fluctuations
The more price fluctuates within a pattern, the more important it is
If the price stands still for a long time, traders and investors inevitably get used to buying at one price and selling at another. That is why the price moving beyond the usual prices changes the whole picture dramatically and represents an important event from the psychological point of view.
3. Significance of pattern depth
The more in-depth the pattern, the greater its significance
A breakout of a wide trading range is much more important than a breakout of a narrow trading range. The bigger (proportionally) the price fluctuations inside the pattern, the stronger the subsequent movement will be. If the pattern is formed by wide price movements, it means that the end of the pattern is likely to be marked by them as well.
It is also important to note that if you get a very narrow rectangle, it means that the battle between buyers and sellers is very balanced. This is especially true if there is almost no trading activity. When the balance is broken for one reason or another, the price will often move faster and further than initially expected.
How To Measure The Impact Of A Breakout
To assess the impact of a breakout, simply measure the distance between the inner boundaries, and then project them downwards. In most cases, the price will go further than the potential target we have highlighted. In very strong movements it will go further by many percent. Moreover, these price range projections often become important support and resistance zones in themselves.
Unfortunately, we cannot determine exactly where the next level will be after the price move, because technical analysis, again, does not allow us to accurately determine the duration of the price movement. However, we can well estimate the probability of whether this zone will be support or resistance. To put it plainly, this approach is a minimum expectation of the price movement.
Cancellation Effect
The minimum distance after a breakout can become a new zone where another accumulation or distribution begins. It usually takes a long period in the new range for the price to move back into the old range.
That being said, if there was a breakout of, say, a 2-year rectangle and price reached the minimum target, even though it didn't go any further, it will usually need the same accumulation/distribution period as it did in the previous range. It is only then that price can move back up.
False Breakout
As we have already found out, a price breakout outside the price pattern, even if it is small, often indicates a trend reversal or its confirmation (if the price was in an accumulation/rectangle). However, it is not uncommon for price to show deceptive, movements, so we need to introduce clear rules to avoid mistakes. It is quite ironic that false breakouts actually confirm the significance of certain support or resistance zones.
For example, on a daily chart, you see a confident breakout of a rectangle. But if the price does not hold above the broken line for more than one day, such a signal becomes suspicious. From a technical point of view, such a breakout can be much less significant, because if it does not hold, it means that the momentum is exhausted.
If the price has uncertainly broken the level, in most cases it turns in the opposite direction to the breakout
A hesitant breakout is often accompanied by further concentration of the price in the range until the price structure is technically prepared for a new breakout. When the price has confidently exited the pattern, this is an indication that the breakout has taken place.
Indications of a false upside breakout: price is moving back into the range and breaking the previous lows, the rising trendline connecting the previous lows.
Indications of a false downside breakout: price moves back into the range, breaks the previous high, a descending trendline connecting the previous highs.
Keep Risk Management In Mind
We remember that an upward breakout indicates a possible price rise. However, the same can be said about a pullback. If the price is back in the range, the probability of it reaching higher values decreases rapidly. Unfortunately, there are no quick and easy ways to determine this in any market conditions. Every market situation is different. This is the reason why you need to think everything through in advance, even before opening a trade. Otherwise, if the trade is already open, your emotions will come into play and affect the result. If you do not think over your risks in advance, if things go badly, you will be emotionally stressed and tense when you exit the trade. You will be influenced by some news, sharp price movements and in general anything except a sober, logical plan thought out in advance.
Let's Summarize
A rectangle is a trading range between two parallel trend lines. We measure the consequences of a breakout: the depth of the pattern is projected in the direction of the breakout. Indications of a false upward breakout: price moves back into the range and breaks the previous lows, the rising trendline connecting the previous lows. Indications of a false downside breakout: price moves back into the range, breaks the previous high, downward trend line connecting the previous highs.
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