How to Trade a Rectangle Consolidation

Rectangle consolidation patterns can lead to amazing profits and are relatively easy to recognize on a chart.  Let’s learn more about this chart pattern.

Eaton Corp (ETN) recently broke out of a rectangle consolidation pattern, which gives us an example of how we could trade such chart patterns.

Sears Holding (SHLD) broke a long-term rectangle that led to large gains in 2005:

The defining characteristic of a rectangle pattern is the ability to draw two clear parallel trendlines that are tested on both sides by price.  Volitility winds down during this time as the stock ‘builds a base’ for an eventual breakout.

The tight price in the pattern is said to be ‘in equilibrium’ or ‘in value’ as buyers and sellers generally agree that those levels represent a fair price and will trade at those levels.

Generally, volume falls as the pattern develops, but increases towards the end of the pattern and sometimes surges on the eventual breakout of the range.

Let’s look at how we might trade this pattern.

The Ideal Rectangle Consolidation Pattern:

Once you recognize a rectangle and can draw parallel channel lines, add the stock to your watchlist and keep your eye on it should it break out.

Alternately, you could aggressively place a buy stop above the upper channel and a sell-stop (to enter short) once price breaks the lower channel.  You’ll either need your program to place stops automatically, or you’ll need to enter them manually once the position triggers.  Alternately, you could place an “alert price” with any number of software or websites.

Let’s assume an upward break.  Place stops conservatively just beneath the upper trend channel (for a high reward/risk ratio), or aggressively place them beneath the lower trend channel (giving the market room).

I prefer to enter on a ‘throwback,’ which often gives you greater odds of continuation and gives you better fill and generally removes the urgency to enter (which leads to higher slippage and eliminates ‘chasing’ the market).  Throwbacks don’t always occur, and so you’ll need to see for yourself which tactic you prefer.

Generally, a conservative target would be the height of the rectangle added to the breakout price to establish an initial target.  Rectangles can be reversal patterns, and so you might sometimes want to use them to establish a position trade, but I prefer fixed targets when trading them.

It’s generally accepted also that the ‘longer the consolidation, the greater the eventual breakout’ so you can take the length (distance) of the rectangle into consideration when making price projections (some people turn the rectangle up – vertical – and then use that as a price projection).

These are interesting patterns and can allow you to have a little fun when a stock breaks out of a consolidation area and makes a new run.  Not all rectangles ‘work,’ but they can offer excellent risk/reward characteristics that allow you to add a new tool to your trading arsenal.