The Rectangle Formation

ImClone Systems: an Example of a Rectangle Formation
Figure 2 of ImClone Systems (IMCL) employs open-high-low-close bars (rather than candlesticks) and is absent of any indicators, such as MACD. The only addition is a 30-week moving average (MA), which could have been calculated in the classical era.

Figure 2

Several observations are worth making on this chart. First, note that an intermediate uptrend line, in force for approximately one year, is broken. The break shows the uptrend has ended. Thus, the prolonged rectangle can either be a reversal or consolidation formation. Until there is a breakdown or breakout from the confines of the rectangle - roughly $37.50 to $47.50 - the pattern's interpretation is uncertain.

Second, horizontal lines drawn on the chart denote significant support and resistance. Significant support was first established in September, tested twice in the early part of the year and retested in June. At each test of support, there was sufficient buying interest to drive the stock higher.

Significant resistance at $47.50 was first touched in August, then probed in October, April and July. At each juncture, the sellers overwhelmed buyers, and the stock receded. This vacillation between significant support and resistance creates the rectangle shape.

One final observation is the slope of the 30-week MA. Of all moving averages, this may best describe the trend. It relates to the rectangle by showing the sideways nature of the formation. In an uptrend or downtrend, the 30-week MA will slope up or down, not sideways. Note how in the early stages of the chart it sloped higher, mimicking the uptrend. Later it flattened and began to slope sideways, showing the prolonged consolidation.

Trading the Rectangle
The following are two basic strategies for trading a rectangle:

  • The first is to buy at support and sell at resistance (one can also sell short at resistance and cover the short sale at support). To mitigate risk, in case the stock breaks down from support, a very tight stop can be employed of perhaps 3%. For example, if one bought ImClone at $37.50, the stop-loss would be 3% lower than $37.50 or $1.12. The trader would exit the position if the stock hit $36.38 ($37.50-$1.12).
  • Another method to trade the rectangle is to wait for the breakout. As with all technical patterns, this breakout should ideally occur on above-normal volume. To know when to consider exiting the trade, the trader could use the measuring principle described below.

The Measuring Principle
The measuring principle allows you to set a specific minimum price target. Such a target should give you the objectivity to hold during periods of minor countertrend movement.

The measuring principle works with any well-defined technical analysis pattern, such as a rectangle or triangle. To calculate the minimum target, first establish the height of the pattern. In the case of ImClone Systems Figure 3 shows the calculation as follows:






10.00 points

Figure 3

For a bullish breakout, once the height of the pattern has been established, add the difference to the breakout level. Since the breakout level is $47.50 and the height 10 points, the minimum target is $57.50. Of course, it may take some time to reach the target, so the trader must be patient. As well, the measuring principle is a statement of probability, not a guarantee. The trader will carefully monitor the technical picture of the stock despite the target.

How was the rectangle in IMCL resolved? Bristol Myers Squibb bid $60 a share to acquire the 83% of ImClone it did not already own. Shareholders who had seen their stock go nowhere for a year, and saw the shares close at $46.44, woke up the next morning to find their stock had opened at $64.16, well beyond the minimum target set by the measuring principle. Those who traded the rectangle, in this case, turned out not to be "square."