Chart patterns produce some of the most successful trading opportunities in the market for technical traders, and they can give either trend reversal signals or continuation signals.
As basic as it is, the rectangle chart pattern is one of the most popular continuation formations in technical analysis.
Depending on the height of the pattern and market condition, the rectangle chart pattern can be a simple price consolidation or a full ranging market that just swings back and forth between two established boundaries.
Interestingly, the pattern is very easy to identify, and a lot of traders trade it, thereby creating huge volatility when the price breaks out of it.
But apart from the breakout, some people trade the range created by the pattern if the range is big enough and the market conditions are right. Continue reading to learn:
What is the rectangle chart pattern?
The rectangle chart pattern is a classical price action chart pattern formed when the price is moving sideways without any significant upward or downward displacement.
It is formed when the price is swinging up and down between two well-established boundaries — an upper boundary that represents a resistance (supply) zone and a lower boundary that represents the support (demand) zone.
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.
The back and forth movement continues until the price eventually breaks out of one boundary and resumes the previous trend or starts a new trend in the opposite direction.
The significance of the rectangle chart pattern
The pattern shows a period of indecision in the market, with the buyers and sellers counterbalancing each other.
While the sellers are defending the resistance zone, the buyers are defending the support zone.
But none of them is serious enough to mount a rallying offensive at the enemy’s territory, so the price keeps swinging up and down between the two zones until one of them gets serious and attacks beyond the enemy’s line — creating a breakout.
Often considered a consolidation in a trend, which makes it a continuation chart pattern, the rectangle pattern can also be a reversal pattern if it is occurring at the accumulation or distribution phase of the market cycle.
Types of rectangle chart pattern
There are two types of the rectangle chart pattern — bullish rectangle and bearish rectangle — which are based on the prevailing price trend prior to the formation of the pattern.
A bullish rectangle is formed when the price consolidates for some periods during an uptrend.
It often results from buyers needing to take a breather and secure their profits while the bears are still not convinced that the bulls are done.
So, the sellers put up a weak fight and don’t push the price that much. If the consolidation lasts for a short period relative to the upswing preceding it, the bullish rectangle is known as a bullish flag.
The USDJPY chart below shows a bullish rectangle. Notice that the moving average is sloping downward, indicating a downtrend.
A rectangle is classified as a bearish rectangle if it is formed when the price is in a downtrend.
It represents a price consolidation during a downtrend, which results probably from sellers taking a break and locking in their profits while the buys are still afraid to mount any serious offensive.
When the consolidation lasts for a short period relative to the downswing preceding it, the pattern is known as a bearish flag.
See the bearish rectangle in the USDJPY chart below. Notice that the moving average is sloping downward, indicating a downtrend.
Tools for trading rectangle chart pattern
If you are very good at reading price action, you can actually trade this chart pattern on its own.
Nevertheless, it may help to make use of other technical analysis tools when analyzing this trading chart pattern.
Some of the tools that you may find helpful are the ones that help you identify the trend direction, such as trend lines and moving averages.
You may also need tools that can help you gauge the price momentum during a breakout.
In this case, you can use the MACD indicator. Other tools you may also find helpful in certain market conditions are oscillators and candlestick patterns.
Strategies for trading the rectangle chart pattern
The rectangle chart pattern is often considered a price consolidation that usually happens in a trend, and the trend is often expected to continue.
So, it is often advisable to trade in the direction of the trend — if the market was in an uptrend before the pattern occurred, you look for buying opportunities, and if the market was in a downtrend, you look for shorting opportunities.
However, there are times when the height of the rectangle may be sizeable enough and the market isn’t quite choppy, making it possible to benefit from trading price reversals at the upper and lower boundaries of the price range.
Though it may be more risky to trade the price range, it can still make a profitable trade.
As you can see, there are different ways traders take advantage of the pattern. So, let’s take a deep look at the various strategies you can use to play the pattern. While there may be other ways, here are the common strategies traders use in trading the pattern:
Trading the breakout
The most common method for trading the rectangle chart pattern is to wait for the price to break out of the pattern and then trade in that direction.
A breakout simply means that the price closed above the upper boundary or below the lower boundary of the pattern, showing that either the bulls or the bears have eventually taken a decisive control of the price direction.
This strategy is very easy to trade because you can easily mark out the upper and lower boundaries of the rectangle and wait for the price to close beyond any of them.
Even a newbie can identify the boundaries, recognize when a breakout happens, and place a corresponding trade in that direction.
There are clear structures that can determine where to place a stop loss order and a limit order if one doesn’t want to enter with a market order.
And, like every other price action chart pattern, it has a measurable profit target. Interestingly, the rectangle chart pattern strategy can be traded in any financial market.One problem with trading chart pattern breakouts is that there are too many false breakouts, and the price can move in either direction.
It is a known fact in technical analysis that the rectangle chart pattern is a continuation formation, which signifies a temporary consolidation in the existing trend.
But it can also occur as a reversal formation, where it marks the accumulation phase of the market cycle that ends a downtrend and precedes an uptrend or the distributive phase that ends an uptrend and precedes a downtrend.
Since the price can effectively breakout in either direction and there are frequent false breakouts, how do you know the breakout that is likely to work?
Of course, you can never know for sure, but studies have shown that about two-thirds of genuine breakouts result in the continuation of the trend.
So, it is safer to stay on the side of the prevailing trend as there is a higher chance that the price will continue in the direction of the trend.
When a breakout occurs in the direction of the trend, the rectangle chart pattern looks more like a flag, especially if the price doesn’t stay too long in the range before breaking out to resume the trend.
For an up-trending market, you have what looks like a horizontal bullish flag, while in a downtrend, you have a horizontal bearish flag.
While you can perfectly trade this price action chart pattern alone, it may be better to use the MACD indicator to confirm the breakout.
When the price is breaking above the chart pattern, the MACD line should be above the signal line and may even be above the zero level.
In the case of a breakout below the chart pattern, the MACD line should be below the signal line or even below the zero level.
Putting it all together, these are the steps to follow when trading a rectangle chart pattern breakout in an uptrend:
-Confirm that the price is trending upward before the rectangle pattern occurs — you can use a trend line, moving average, or just the series of swing highs and lows
-Identify the rectangle pattern and mark the upper and lower boundaries — the price must have reversed twice at each of these boundaries for the pattern to qualify as a rectangle chart pattern
-Wait for the price to close above the upper boundary of the pattern
-Confirm that the MACD line has crossed above the signal line and if it is above the zero level too, it’s better
-Open a buy position at the opening of the next price bar
-Place a stop loss order a few pips below the lower boundary of the rectangle pattern if the size of the pattern is small or at the middle of the pattern if the pattern is big-sized
-Put a profit target at 2:1 reward/risk ratio — so, if your stop loss is below the pattern, your profit target should be 2x the size of the pattern, and if your stop loss is at the middle of the pattern, your profit target should be the size of the pattern measured from the breakout point
The USDJPY chart below shows an uptrend (blue trend line) and a rectangle chart pattern formation.
When the price broke above the rectangle, the MACD line has crossed above the signal line. Notice the positions of the stop loss and profit target.
When trading the rectangle chart pattern breakdown in a downtrend, these are the steps to follow:
-Use a trend line, moving average, or even a series of descending swing lows and highs to confirm that the price was in a downtrend prior to the rectangle pattern formation
-Spot the bearish rectangle pattern and mark the lower and upper boundaries
-Wait for a price close below the lower boundary of the pattern
-Be sure that the MACD line has crossed below the signal line — it is even better if the MACD line is below the zero level too
-Enter a sell position at the opening of the next price bar
-Put a stop loss order some pips above the upper boundary of the rectangle pattern if the size of the pattern is small or at the middle of the pattern if the pattern is large
-Aim for a profit target of at least 2:1 reward/risk ratio — thus, if your stop loss is above the pattern, your profit target should be 2x the size of the pattern, and if your stop loss is at the middle of the pattern, your profit target should be the size of the pattern measured below the lower boundary
In the chart below, the price was in a downtrend before the rectangle chart pattern occurred, as shown by the moving average line.
Notice that the MACD was already below the zero level before the breakout, and it crossed below the signal line when the breakout occurred. Note the positions of the stop loss and profit target.
Trading a false breakout at the other end
Another way to trade the rectangle chart pattern is to trade a false breakout against the prevailing trend direction.
In this strategy, you aim to trade in the direction of the trend that was in place before the rectangle pattern formed, but rather than wait for a normal breakout to occur, you use a false breakout in the opposite direction as an early entry signal.
The rationale is that a false breakout is a sign that the real breakout will occur at the other end.
False breakouts are often caused by institutional traders when they are searching for orders to fill theirs.
They lure in traders in one direction and push the price in their intended direction when they have filled their own orders.
The interesting thing here is that they create a false breakout opposite to the pre-existing trend.
So, you have two factors in your favor — an existing trend and a false breakout, which is often regarded as the smart money footprint indicating a price move in the opposite direction (in this case, the direction of the trend).
While some risk-averse traders may only use a false breakout against the trend as an extra layer of confirmation to trade the real breakout in the trend direction, risk takers aim to enter the market immediately the price reverts into the range and heads towards the other end.
It may be a risky strategy, but it affords you a tighter stop loss and a higher reward/risk ratio.
The strategy combines a range trading method (spring and upthrust) with a trend-following strategy.
Here is how to trade the false breakout strategy in an uptrend:
-Be sure that the price is in an uptrend before the formation of the rectangle pattern — if need be, use a trend line or moving average to confirm
-Spot the rectangle pattern and establish the upper and lower boundaries
-Look for a downward breakout at the lower boundary and wait for the price to turn upwards and move back into the chart pattern
-Enter a buy position when the next candlestick opens above the lower boundary of the chart pattern
-Place your stop loss order some pips below the low of the false breakout
-You can have two profit targets: the first one just below the upper boundary of the chart pattern, and the second one should the size of the rectangle measured from the upper boundary of the pattern or even double of the size of the pattern
An alternative method is to just use the second profit target and bring your stop loss to breakeven when the price reaches the upper boundary of the pattern.
This AUDUSD chart below shows an uptrend — a rising moving average line — prior to the formation of a rectangle chart pattern.
There was a false breakout below the lower boundary of the pattern. The price climbing back above the lower boundary was an indication to go long.
Since the rectangle was a tight consolidation, it makes sense to use only the second profit target — 2x the size of the chart
In a downtrend, these are the steps to follow when trading the strategy:
-Confirm the downtrend with a trend line, moving average, or price action — a series of descending swing lows and highs
-Identify the rectangle pattern and establish the upper and lower boundaries
-Wait for the price to break above the upper boundary and later turn back downwards, falling into the chart pattern
-When the price closes below the upper boundary, place a sell order if the next candlestick opens within the chart pattern and heads towards the lower boundary
-Place your stop loss order some pips above the high of the false breakout You can have two profit targets :
The first one just above the lower boundary of the pattern, while the second one should the size of the rectangle measured downward from the lower boundary of the pattern or even double of the size of the pattern.
Alternatively, you may just use the second profit target and bring your stop loss to breakeven when the price hits the lower boundary of the pattern.
In the GBPUSD below, you can see a market in a downtrend. Notice the false breakout above the upper boundary of the rectangle pattern.
The price falling back below the upper boundary was an indication to short. Since the pattern is sizeable, you can have two profit targets: TP1 and TP2.
Trading the range
Depending on the size of the rectangle chart pattern and the market condition — highly volatile choppy market or relatively quiet market with average-sized candlesticks — it may be possible to trade the pattern as a range.
If the distance between the two boundaries are large enough to offer a reasonable profit and the market is moving nicely (not choppy), you can trade the range as the price swings from one boundary to the other.
But you don’t just trade the range like that. Conservative traders may even want to trade the range only in the direction of the preceding trend, but usually, most people trade in both directions.
Whatever the case, you need other supporting tools to help you confirm when the price has turned to a new direction after hitting any of the boundaries. Some of the tools you can use include:
Reversal candlestick patterns: Examples include the hammer, shooting star, inside bar, and engulfing patterns. At the upper boundary, look for bearish reversal patterns, such as the shooting star, bearish inside bar, and bearish engulfing patterns, while at the lower boundary, you look for bullish reversal patterns, such as the hammer, bullish inside bar, and bearish engulfing patterns.
Spring and upthrust: The spring pattern is a false breakout at the lower boundary; it has a bullish implication.
On the other hand, the upthrust has a bearish implication, and it is basically a false breakout at the upper boundary.
Oscillator divergence signal: The divergence between the price swings and an oscillator indicator, such as stochastic, RSI, or CCI, can be a useful signal. Look for bullish divergence at the lower boundary and bearish divergence at the upper boundary.
Oscillator overbought/oversold signal: An oscillator also produces an overbought signal when the indicator is descending from the overbought region and an oversold signal when the indicator is rising from an oversold region.
Oversold signals have bullish implications, so look for them when the price is at the lower boundary of the range. At the upper boundary, look for overbought signals since they have bearish effects.
Putting it all together, here is how to trade a tradable rectangle price range:
-Wait for the price to hit any of the boundaries
-At the upper boundary, go short when you spot the upthrust pattern, a bearish reversal candlestick pattern, a bearish divergence, or the overbought signal.
Place a stop loss above the high of the swing you are trading and put your profit target above the lower boundary of the range.
-At the lower boundary, go long when you see the spring pattern, a bullish reversal candlestick, a bullish divergence, or the oversold signal.
Place your stop loss below the low of the swing you are trading and put your profit target below the upper boundary of the range.
The chart below shows a sizeable rectangle that can be traded as a range market. Notice the reversal candlestick patterns (hammer, shooting star, and engulfing bar) at the upper and lower boundaries. Take note of the stop losses and profit target positions.
This chart below is another range market. You can see an upthrust pattern at the upper boundary and two spring patterns at the lower boundary. Take note of the positions of the stop losses and the profit targets.
Mistakes to avoid when trading rectangles chart pattern
Some traders, especially beginner traders, make several mistakes when trying to trade the rectangle chart pattern. These are the most common ones:
Trading the breakout randomly: Just like every breakout strategy, the rectangle chart pattern does have a lot of false breakouts.
So, trading the pattern randomly would lead to having too many unnecessary losing trades.
The best way to trade the chart pattern is to trade only the breakouts that occur in the direction of the trend or use other signals, like an opposite false breakout, to identify the most likely direction the price will head to.
Trading the price range when the market is choppy: While some rectangles can be traded as a ranging market, some may be too choppy to get any reasonable pips out of the market. It is always better to avoid trading such market conditions.
The rectangle chart pattern is formed when the price swings up and down between a resistance and a support zone, without making any vertical advancement beyond these boundaries.
It shows there is an equilibrium between buying and selling. Some of the ways to trade the pattern include trading the breakouts, the false breakouts, and the price swings within the pattern if the market situation is right for that.