Rectangle Setup

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Rectangle Top Setup: Summary

If you can recognize a rectangle top in time to use this trading setup, it can result in a profitable trade 75% of the time.

Set a buy stop a penny above the top of a rectangle top chart pattern and above a 21-day simple moving average. When price breaks out of the chart pattern, the stop should get you in. Sell at the close three trading days later. The setup makes, on average, over 3% in 5 calendar days with a win/loss ratio of over 7. Yes, 7.

Rectangle Top Setup: Background

The figure on the right is the ideal rectangle top chart pattern. Price enters the pattern from the bottom and bounces between two horizontal or nearly horizontal trendlines. In this example, price exits the rectangle top from the bottom but it need not. In fact, testing shows the breakout is upward 68% of the time.

Rectangle Top 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 top 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 tops are known valid chart patterns.

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

Each trade assumes a starting portfolio value of $10,000. Commissions of $10 each way ($20 round trip) are included, but no allowance for slippage, taxes, fees, and so on. Any profits were not reinvested in the next trade.

Rectangle Top 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, based on an investment of $10,000 per trade minus $10 for commissions each trade ($20 round trip).

% 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 toped. 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
1.	Buy price >21 day SMA, 3 day exit	$309.66	3.1%	75%	$360.21	$50.54	7.13	28%	16%	5	599
2.	Buy price <200 day SMA, 3 day exit	$336.05	3.4%	76%	$414.82	$78.78	5.27	19%	11%	5	54
3.	3 day or 5% exit, no stop	$263.79	2.6%	78%	$312.32	$48.50	6.44	11%	16%	4	602
4.	Buy price >50 day SMA, 3 day exit	$304.84	3.0%	75%	$359.38	$54.54	6.59	28%	16%	5	599
5.	2 day exit	$278.33	2.8%	74%	$328.72	$50.39	6.52	16%	16%	4	602
6.	5% profit, stop at halfway between buy price and fmtn low	$319.63	3.2%	79%	$415.34	$95.72	4.34	14%	10%	11	602
7.	3 day exit	$320.69	3.2%	75%	$358.41	$55.72	6.43	28%	16%	5	602
8.	Buy price >200 day SMA, 3 day exit	$297.07	3.0%	75%	$351.07	$53.99	6.50	28%	16%	5	542
9.	5% profit, stop: fmtn-.01	$336.36	3.4%	86%	$450.33	$113.97	3.95	21%	16%	15	602
10.	2 day exit, stop is buy day's low-.01	$261.43	2.6%	70%	$319.17	$57.74	5.53	16%	9%	4	602
11.	3 day exit, stop at low on buy date-.01	$340.79	3.4%	68%	$340.79	$67.43	5.05	28%	9%	5	602
12.	3 day exit. Stop: lower of today or yesterday -.01	$298.37	3.0%	74%	$357.77	$59.41	6.02	28%	11%	5	602
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
13.	6% profit exit, stop: fmtn-.01	$395.87	4.0%	84%	$522.28	$126.41	4.13	26%	18%	19	602
14.	4 day exit	$385.03	3.9%	75%	$385.03	$54.56	7.06	41%	23%	7	602
15.	7% profit exit, stop: fmtn-.01	$432.58	4.3%	82%	$582.42	$149.85	3.89	26%	18%	23	602
16.	5 day exit	$352.33	3.5%	75%	$416.83	$64.60	6.45	41%	23%	8	602
17.	8% profit exit, stop: fmtn-.01	$449.95	4.5%	79%	$641.31	$191.36	3.35	26%	18%	28	602
18.	5% profit, stop at buy day's low -.01	$246.99	2.5%	63%	$336.10	$89.11	3.77	14%	9%	7	602
19.	Exit day after a lower close	$170.91	1.7%	69%	$303.58	$132.67	2.29	19%	8%	5	602
20.	10% profit, stop at buy day's low -.01	$331.99	3.3%	47%	$481.30	$149.31	3.22	28%	11%	16	602
21.	9% profit exit, stop: fmtn-.01	$478.50	4.8%	76%	$698.61	$220.11	3.17	29%	25%	32	602
22.	Exit day after a lower low	$185.93	1.9%	68%	$327.32	$141.39	2.32	21%	9%	6	602
23.	10% profit exit, stop: fmtn-.01	$500.26	5.0%	74%	$747.07	$246.81	3.03	35%	25%	36	602
24.	Exit day after a lower high	$177.87	1.8%	68%	$319.53	$141.66	2.26	21%	23%	5	602
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 Top 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 Top Setup: Trading Example

I show Fortune Brands (FO) on the daily scale with a rectangle that appears in March to April 2010.

Price moves horizontally, touching or coming close to the bottom and top trendlines several times, but still looking irregular. This might also work as a descending triangle.

With a price buy price set a penny above the top of the chart pattern, it triggers on April 9 at 50.09. Since price is above the 21-trading day simple moving average, (incidentally, the 21-day was chosen in tests simply because that's how many days are in the average trading month and for no other reason), it qualifies as a valid buy according to the best ranked trading setup.

A sell occurs at the closing price three trading days later, April 14, at 52.37 for a gain of $436, or a 4.4% gain on a $10,000 investment in 5 calendar days.