Rectangle Chart Pattern Strategy (Backtest And Example)
Last Updated on November 9, 2022
If all chart patterns are as simple as the rectangle pattern, every technical trader would be a chartist of some sort. One of the most popular chart patterns every trader should know, the pattern is easy to spot. But what is the rectangle chart pattern strategy?
The rectangle chart pattern is a continuation pattern that forms a trading range during a pause in the trend. Sometimes referred to as a trading range, consolidation zone, or congestion area, the strategy for trading this pattern is to buy at the support and sell at the resistance if the rectangle is high enough or to trade the breakout above the resistance or below the support.
In this post, we take a look at the rectangle chart pattern strategy. We end the article with a backtest of both rectangle bottoms and tops.
What is the rectangle chart pattern strategy?
The rectangle chart pattern is a classical price action chart formation that occurs when the price is moving sideways without any significant upward or downward displacement. It is a continuation pattern that forms a trading range during a pause in the trend.
A rectangle pattern is sometimes referred to as a trading range, consolidation zone, or congestion area. The strategy for trading this pattern is to buy at the support and sell at the resistance if the rectangle is high enough or to trade the breakout above the resistance or below the support.
The pattern is formed when the price movement is limited between two well-established boundaries — an upper boundary that represents a resistance (supply) zone and a lower boundary that represents the support (demand) zone.
Here’s what happens in the rectangle: when the price gets to the lower boundary, it turns and heads upwards until it gets to the upper boundary, where it also reverses and starts moving downward. This back-and-forth movement continues until the price eventually breaks out of one boundary and resumes the previous trend, as you can see in the image below:
How to identify a rectangle chart pattern
A rectangle is a chart pattern formed when the price is bounded by parallel support and resistance levels. You confirm a support level when there are at least two swing lows that reverse at that level. In a similar way, you confirm a resistance level if there are at least two swing highs that reverse at that level.
So, you identify a rectangle chart pattern when you see two comparable highs and two comparable lows. You then connect the swing highs with a horizontal line and the swing lows with another horizontal line. With that, you have two parallel lines that make up the upper and lower boundaries of a rectangle. See the chart below:
What does the rectangle chart pattern tell you?
Sometimes referred to as a trading range, consolidation zone, or congestion area, the pattern shows a period of indecision in the market, with the buyers and sellers counterbalancing each other. The sellers try to defend the resistance zone anytime the price reaches there, while the buyers defend the support zone anytime the price comes close.
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However, neither the sellers nor the buyers are serious enough to push the price beyond the boundary, so the price keeps swinging up and down between the two zones. This would continue until one of them gets serious to push the price over — creating a breakout.
Often considered a consolidation in a trend, a rectangle is seen as a continuation chart pattern. But the pattern can also be a reversal pattern if it is occurring at the accumulation or distribution phase of the market cycle. In fact, the triple top or triple bottom pattern, which is the hallmark of the distribution/accumulation phase, can also be viewed as a rectangle reversal pattern.
Where does it come from, and what is its history?
The rectangle is a classical technical analysis pattern described by horizontal lines showing significant support and resistance. It has been in use since the origin of chart analysis in the Western world — when charts were kept by hand on graph paper.
Since the rectangle is an example of a “price pattern” in technical analysis and price patterns derive from the works of Richard Schabaker, Edwards, and Magee, who wrote what many consider the bible on the subject, those men can be considered the origin of the rectangle pattern.
What are the rules of the rectangle chart pattern?
The two main rules to have a rectangle chart pattern are as follows:
- The trend: For most rectangles, there is a preceding trend. If the trend is not too old, the rectangle would likely be a continuation pattern — the more mature the trend, the less chance that the pattern marks a continuation.
- The swing highs and lows: At least two equivalent swing lows to form the lower support line and two equivalent swing highs are required to form the upper resistance line. While they do not have to be exactly at the same level, they should be within a reasonable proximity.
To trade a breakout of the rectangle, use the following trading rules:
- The breakout is in the direction of the trend
- The breakout is in the opposite direction of a prior false breakout
- The breakout is associated with a high trading volume
Pros and cons of the rectangle strategy
The pros of trading a rectangle include:
- You can identify the support and resistance levels
- You can trade the price swings within the rectangle if they are large enough to make some reasonable profit.
- When trading the breakout, you can easily measure the price target by projecting the height of the rectangle from the point where the price broke out.
Trading the rectangle pattern also comes with some demerits, such as these:
- When trading the breakout, to have a good stop loss, you place it at the other end of the pattern, which makes the reward/risk unappealing.
- When the rectangle is narrow, the price movement after the breakout tends to be more explosive, and using the height of the rectangle to determine your profit target may lead to leaving a lot of profit on the table.
Rectangle chart pattern example
The rectangle pattern is quite common on stock charts. The chart below shows an example of the rectangle strategy:
Note the breakout entry, the measured profit target, and stop loss levels. The profit target is the height of the rectangle measured from the breakout level.
Rectangle chart pattern strategy backtest
It’s pretty demanding to make a rectangle chart pattern strategy with strict trading rules and settings because of all the rules required.
Instead, we rely on data from Thomas Bulkowski’s book from the late 90s called The Encyclopedia of Chart Patterns. His book is not based on strict quantified rules or data driven backtests, but rather on visual confirmation. Nevertheless, we believe his findings are a decent approximation.
Bulkowski, an engineer, sat down and went through technical formations for 500 stocks over a period of five years. This gave a total database of 2 500 years, although of course there are sources of error as all the stocks are from the same time period. In total, he registered over 15 000 technical formations, of which he divided rectangles into two groups: Rectangle bottoms and rectangle tops.
Let’s start with the results for rectangle bottoms:
|Description||Upside breakout||Downside breakout|
|#Formations among 500 stocks from 1991 to 1996||41||54|
|Reversal or consolidation||41 reversals||54 consolidations|
|#False signals||0%||2 (4%)|
|Average rise/decline of successful formations||46%||19%|
|Most likely rise/decline||20%||10 to 15%|
|#Formations that reached the price target||38 (93)%||34 (65%)|
|The average length of the formation||3 months (84 days)||3 months (87 days)|
The table indicates a reliable formation. Of course, this is not a formation that is 100 percent objective, but it is quite possible to draw some pleasant conclusions from this.
Let’s look at the opposite rectangle pattern – the rectangle top:
|Description||Upside breakout||Downside breakout|
|#Formations among 500 stocks from 1991 to 1996||140||62|
|Reversal or consolidation||140 consolidations||62 reversals|
|#False signals||3 (2%)||0|
|Average rise/decline of successful formations||52%||20%|
|Most likely rise/decline||20 to 30%||20|
|#Formations that reached the price target||125 (91)%||34 (65%)|
|The average length of the formation||3 months (97 days)||3 months (85 days)|
Both tables indicate that the rectangle chart pattern strategy is a pretty robust and reliable formation as long as you have a breakout from the “base” or consolidation.
Rectangle chart pattern strategy – ending remarks
We were not able to develop a 100% quantified rectangle chart pattern strategy.
Nevertheless, Thomas Bulkowski’s statistics from his best-selling book shed some light on the probabilities of making money on this particular formation. But we recommend being cautious due to the lack of 100% quantified trading rules. Bulkowski’s research is based on after the fact analysis. As a matter of fact, you should be cautious about any technical analysis that is not based on 100% verifiable rules. There is a reason why the name of the website is Quantified Strategies! You can have a look at our good and profitable trading strategies, or you can find our absolute best strategies behind a paywall: