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Monday, February 11, 2008

RECTANGLE PATTERN – Part 2: Important Characteristics

Go back to Part 1: Rectangle Formation

Important Characteristics of Rectangle Pattern:

Existing Trend:
There should be an established existing trend (either uptrend or downtrend) in order for the pattern to qualify as a continuation pattern.

Shape of Rectangle Pattern:
* There should be at least 4 reversal points to draw two parallel lines, i.e. two equivalent peak (high) points forming a horizontal upper line (resistance) and two equivalent trough (low) points forming a horizontal lower line (support).
* There should be some distance between the two peaks as well as the two troughs
In other words, prices should increase and hit the horizontal upper line then decline for at least twice (forming at least two peaks). Prices should drop and hit the horizontal lower line then bounce up for at least twice (forming at least two troughs).

Unlike Triangle pattern whereby volume should be diminishing as the triangle develops, for Rectangle pattern there is no standard pattern for the volume.

Volume could sometimes be contracting as the Rectangle is forming, but it might be fluctuating as well.
The fluctuation can be random, or may also show certain tendency.
For example, volume tends to increase as the price is nearing to resistance (upper line), and decreasing as the price moves toward support (lower line).
When such volume pattern happens, it could offer an indication on the possible breakout direction (in this example, it might break out to the upside).

When breakout occurs, volume should be expanding.

On a daily chart, this pattern may take from few weeks to many months to form.
If the pattern duration is less than 3 weeks, it is usually considered as a bullish / bearish flag.

Generally, the longer the duration of the pattern, the more significant the breakout would be.
A 3-month pattern might be expected to meet its breakout’s potential price target.
However, a 6-month pattern is likely to exceed its breakout target.

Breakout Direction:
Breakout from Rectangle pattern can happen in either direction (upside or downside).
Hence, the direction of the breakout can only be determined after the breakout has occurred.

Potential Price Target:
1) Compute the height of the Rectangle: The distance between the upper line (resistance) and lower line (support).
2) To compute the potential price target:
When the breakout is to the upside of the upper line: Add the result to the upper line.
When the breakout is to the downside of the lower line: Subtract the result from the lower line.

Return to Breakout Level:
After the breakout occurs, it is common that prices may return to the breakout level for an immediate test of this new support (when break to the upside) or resistance level (when break to the downside) before continuing their moves in the direction of the breakout.
This could actually offer an opportunity to participate in the breakout with a better reward to risk ratio.

Breakout Confirmation:
* A minimum penetration criteria for a breakout should be price closes outside the upper line (for breakout to the upside) or lower line (for breakout to the downside), not just an intraday penetration.
Some traders may apply certain price criteria (e.g. 3% - 5% break from the upper / lower line depending on the stock’s volatility) or time criteria (e.g. the breakout is sustained for 3 days) to confirm the validity of the breakout.
* If the price returns back inside the Rectangle on a closing price basis, the breakout can be deemed invalid.

To read about other chart patterns, go to: Learning Charts Patterns.

Related Topics:
* FREE Trading Educational Videos on Technical Analysis You Should Not Miss
* Learning Candlestick Charts
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks