To start the rectangle, a rally to a completely new high will be followed by a drop to an intermediate support level. Then, the high will be tested by a new rally to then be pulled back once more. Finally, an upside breakout (strong volume) will follow the third and final rally. By adding the difference between the reaction low to the breakout and the first top, the technical target can be analysed.
Although rectangle is the general term used, you may also find the phrases consolidation zones, trading ranges, and congestion areas.
Four Points - Because it is a rectangle as opposed to a triangle, four points are required - two reaction highs forming the upper resistance line and two reaction lows for the lower support line. Although they don’t have to be exactly equal, they are often very close to each other. A common misconception is that they have to alternate between high and low but, although it is preferred, it isn't a must.
Trend - A prior trend needs to have existed for it to be considered a continuation pattern and it should have a life of a few months, not too mature. As the trend becomes more mature, the pattern is likely to be a continuation.
Duration - For anything less than three weeks, it is normally considered to be a flag because between this point and a few months is about average. In a perfect scenario, the pattern will develop over a period of three months with a bigger breakout coming after a longer wait. Whilst a three months pattern would go as expected at breakout, a six month pattern should go above and beyond expectations.
Volume - As the pattern develops, it is common for the volume to decline but volume patterns are not standard as seen with the symmetrical triangle. Often, the fluctuating prices will severely affect the volume levels. As the pattern matures, it is very rare to see the volume increase. For confirmation, it is always good to look for an expansion on the breakout when the volume declines. On the other hand, movements will need to be assessed fully when volume fluctuates. When the volume is assessed in this way, an estimate of the future breakout can be attained.
Breakout Direction - As with most others, the direction of the breakout can only really be determined after the breakout itself. Just like the symmetrical triangle, the direction of the breakout will decide the pattern of the rectangle.
Confirmation - If the breakout is going to be considered as ‘valid’, it will have to be on a closing basis. For confirmation purposes, some traders will apply different filters to the volume, price, and time.
Return to Breakout - As we know with technical analysis, broken support will change into the potential of resistance; the opposite is also true. Sometimes, there is a return to the support level after a breakout above resistance and vice versa. If this is to occur, it gives traders another chance to participate in the trend.
Target - By applying the height of the rectangle to the breakout, the estimated move can be found.