Rectangle Setup

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This article discusses trading rectangle bottom chart patterns using a new setup.

Rectangle Bottom Setup: Summary

The best performing trading setup begins with price rising above the rectangle bottom. Sell at the close three trading days later or if profits reaches or exceeds 5%. No stop is used.

The average trade using this setup makes about 2.5% in 5 calendar days, wins 73% of the time, and has a win/loss ratio of 4.83. The average loss, $65, is small compared to the average win, $314.

Rectangle Bottom Setup: Background

Shown on the right is an ideal rectangle bottom chart pattern. Price enters the rectangle from the top, which is how you distinguish it from rectangle tops.

Price bounces up and down, touching two horizontal or nearly horizontal trendlines, forming a rectangular shaped pattern of sideways price movement. Eventually, price will close above the top of the pattern (an upward breakout) or below the bottom of it (downward breakout). When a breakout happens, that's the time to initiate a trade.

The following tests take advantage of price behavior like throwbacks, and all pertain to upward breakouts.

Rectangle Bottom Setup: Methodology

Since I have used these same tests on other chart patterns, I dispensed with in-sample tests and just used out of sample. This was also necessary because of the scarcity of rectangle bottom chart patterns in my database.

I conducted tests on about 1,550 stocks going back as far as mid 1991 and as recent as June 2010. I only used chart patterns that I have found, not those located by an automated program. Thus, the rectangle bottoms are known valid chart patterns.

The following tests reveal short-term trading setups, not buy and hold situations.

Rectangle Bottom Setup: Results

The various results from the tests are listed below and an explanation of each test is in the next section. Here are the column definitions.

The Rank column is a rank of the sum of the ranks of many but not all of the columns. The sum with the lowest total is the best. The best performing test is listed first.

The Per Trade Avg P/L columns are the average profit or loss per trade in dollars and percent. Both are based on an investment of $10,000 per trade minus $10 for commissions each trade ($20 round trip). No allowance for slippage or other fees were included, and no allowance for cash factored into the tests.

% Wins is the percentage of winning trades. Avg Win is the average of all winning trades. Avg Loss is the average of all losing trades. W/L Ratio is the average win divided by the average loss. If losses are larger than the average win, then the value will be negative.

Max Drawdown is the largest equity drop from peak to valley during the trade. It represents how much profit you give back (worst case). Hold Time Loss is the maximum drop below the buy price during the trade. It represents how much money you could have lost if you sold when price bottomed. Hold Time is the average time the stock was held. # Trades is the number of trades counted in the test.

Rank	Test	Per Trade Avg P/L	Per Trade Avg P/L	% Wins	Avg Win	Avg Loss	W/L Ratio	Max Drawdown	Hold Time Loss	Hold Time	# Trades
0.	3 day or 5% exit, no stop	$248.64	2.5%	73%	$313.63	$65.00	4.83	12%	12%	5	261
1.	Buy price >200 day SMA, 3 day exit	$246.22	2.5%	68%	$304.13	$57.91	5.25	26%	8%	5	161
2.	3 day exit	$243.96	2.4%	69%	$318.35	$74.39	4.28	26%	19%	5	261
3.	Buy price >21 day SMA, 3 day exit	$246.03	2.5%	69%	$321.48	$75.45	4.26	26%	19%	5	256
4.	2 day exit	$213.19	2.1%	68%	$287.81	$74.62	3.86	15%	11%	4	261
5.	Buy price <200 day SMA, 3 day exit	$233.58	2.3%	71%	$335.53	$101.94	3.29	12%	19%	5	99
6.	5% profit, stop at halfway between buy price and formation low	$326.85	3.3%	78%	$440.26	$113.41	3.88	20%	16%	12	260
7.	5 day exit	$309.03	3.1%	72%	$398.06	$89.03	4.47	38%	19%	8	261
8.	Buy price >50 day SMA, 3 day exit	$234.44	2.3%	68%	$312.81	$78.38	3.99	26%	19%	5	224
9.	4 day exit	$276.49	2.8%	70%	$357.23	$80.74	4.42	38%	19%	7	261
10.	3 day exit. Stop: lower of today or yesterday -.01	$200.13	2.0%	68%	$312.67	$112.53	2.78	26%	12%	5	261
11.	7% profit exit, stop: fmtn-.01	$429.35	4.3%	83%	$607.78	$178.33	3.41	41%	36%	24	259
Rank	Test	Per Trade Avg P/L	Per Trade Avg P/L	% Wins	Avg Win	Avg Loss	W/L Ratio	Max Drawdown	Hold Time Loss	Hold Time	# Trades
12.	2 day exit, stop is buy day's low-.01	$162.89	1.6%	64%	$279.53	$116.64	2.40	15%	7%	4	261
13.	5% profit exit, stop: fmtn-.01	$331.82	3.3%	86%	$479.05	$147.23	3.25	41%	36%	18	259
14.	9% profit exit, stop: fmtn-.01	$521.74	5.2%	79%	$730.71	$208.97	3.50	41%	36%	32	258
15.	6% profit exit, stop: fmtn-.01	$369.59	3.7%	84%	$540.57	$170.99	3.16	41%	36%	21	259
16.	8% profit exit, stop: fmtn-.01	$459.81	4.6%	80%	$662.93	$203.13	3.26	41%	36%	28	259
17.	5% profit, stop at buy day's low -.01	$210.61	2.1%	61%	$352.36	$141.75	2.5	17%	11%	8	261
18.	3 day exit, stop at low on buy date-.01	$179.70	1.8%	61%	$301.62	$121.93	2.47	26%	10%	5	261
19.	Exit day after a lower close	$81.14	0.8%	63%	$267.72	$186.58	1.43	15%	6%	4	261
20.	Exit day after a lower high	$87.37	0.9%	63%	$274.49	$187.13	1.47	15%	7%	5	261
21.	10% profit exit, stop: fmtn-.01	$477.39	4.8%	75%	$770.06	$292.67	2.63	47%	36%	36	257
22.	10% profit, stop at buy day's low -.01	$379.76	3.8%	58%	$596.94	$217.18	2.75	27%	24%	21	260
23.	Exit day after a lower low	$93.10	0.9%	62%	$295.90	$202.80	1.46	20%	7%	6	261
Rank	Test	Per Trade Avg P/L	Per Trade Avg P/L	% Wins	Avg Win	Avg Loss	W/L Ratio	Max Drawdown	Hold Time Loss	Hold Time	# Trades

Rectangle Bottom Setup: Test Explanation

Unless otherwise specified, trade entry uses a buy stop a penny above the top of the formation (a penny above the highest high in the chart pattern). For the exit, sell at the close (as in the case of "3 day exit," for example) or the opening price the day after the exit signal. "Buy price >200 day SMA, 3 day exit," for example, means to set a buy stop a penny above the top of the rectangle only if that price is above the 200-day simple moving average (SMA) on the buy day. Once into the trade (day 1), sell at the close of day 4.

Rectangle Bottom Setup: Trading Example

Pictured above is an example of "Buy price >200 day SMA, 3 day exit," the second best performing trading setup tested. It shows the stock from Empire District Electric (EDE), an electric utility company, on the daily scale.

This is a rectangle bottom because price enters the pattern from the top and not the bottom. The rectangle has an irregular appearance but price glides along two horizontal trendlines for over a month.

When price rises above the top trendline, that is the entry signal, providing that the buy price is also above the 200-day simple moving average. In this example, it is.

Three days after entry, sell the stock at the close of that day, as shown on the chart. Unfortunately this trade ends in a small loss.