Recommended
Technical Analysis of Stock Trends
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Friday September 03, 2010 |
Rectangle
Technically speaking, a rectangle is
a rally to a relative new high, pullback to an intermediate support
level, a second rally to test the new high, a second pullback to
intermediate support, a third rally to test the new high level
followed by an upside breakout on strong volume.
Why Does It Happen?
At first and perhaps even second glance, a rectangle may seem
to be little more than another variation of the double top pattern
but while the two technical formations do share some important
characteristics, we need to remember that the double top is a
reversal pattern while the rectangle is continuation
pattern. Rectangles almost always take shape after a stock
has been trending strongly and typical last 4 - 6 weeks in
duration. Although the fundamental news that gave birth to
the strong trend is still valid, investors need an opportunity to
digest the recent move. The stock falls into a "holding
pattern" delineated by near horizontal support and resistance
zones. During this phase both support and demand are roughly
in equilibrium. Buyers may still like the stock but they are
not willing to "chase" the price significantly
higher. Thus they choose to take profits into strength to a
certain level and become aggressive buyers on a pullback to a
certain level. The pattern begins when a well-liked stock
moves to a new high on strong volume. As the
"story" of the stock becomes more widely accepted
investors are willing to pay increasingly exorbitant prices but
one day investors find the price is simply too high, the stock
puts-in a top and prices begin to fall (top#1). This
first top will normally be sufficient to force many of the more
speculative investors from the stock. As they sell the price
of the stock falls further but many investors will not sell
regardless of how far the price falls because they refuse to take
a loss. After several sessions (sometimes weeks) of poor
price performance the stock will begin to stabilize (reaction
low) then gradually move higher. In most
cases this second advance will occur because of some fundamental
factor like a positive fundamental development. As the stock
rises volume slows and investors who bought at the first top get
ready to exit positions into further strength. This
selling pressure creates a surge in volume and the stock soon
retreats (top #2). As the second top is
created, sentiment turns more bearish. Although the flow of
news is still positive, pundits begin to talk about rich valuations
and buyers step back. At this time speculators begin to add
short positions, sensing that a larger decline is about to
unfold. The stock works gradually lower and volume begins to
accelerate. In short order the stock is once again testing
the reaction low and sentiment is bearish but somehow, the stock
manages to hold that key support level and work modestly higher on
stronger volume. A subtle rally begins but speculators
continue to add short positions because sentiment remains
poor. Days later a positive fundamental development occurs
and the stock begins to move toward tops #1 and #2 on heavy
volume. The next session Wall Street analysts make
positive comments and the stock surges through what had been key
resistance at the old highs. Speculators begin to
panic and their short covering during a period when supply
of stock is limited leads to further gains. A new trending
phase begins and the stock moves to substantial new highs in the
weeks ahead.
How Are Technical Targets Derived?
The technical target for a
rectangle is derived by adding the point difference between top#1
and the reaction low to the new breakout level.
Rectangle for Hewlett Packard
Vital Signs
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Rectangles are continuation
patterns and that means they typically represent little more
than a brief period of consolidation in a strong trend.
Although we have written about a rectangle in an uptrend,
these patterns are just as likely to occur in downtrends.
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Rectangles are usually 4 - 6
weeks in duration and always feature very well-defined support
and resistance levels characterized by horizontal lines.
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During the rectangle phase,
supply and demand is said to be near equilibrium as buyers
catch their breath and attempt to digest the most recent
trending period.
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Upside breakouts
often lead to small 2-3% rallies followed by an immediate test
of the breakout level. If the stock closes below this
level (now support) for any reason the pattern becomes
invalid.
We now know that rectangles have a
great deal in common with the other "square"
patterns. Now let's take a look at technical patterns with different
geometry, triangles.
cup
with handle 
ascending
triangle
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