By Dr. Mircea Dologa, MD, CTA*
Posted: Oct 17, 2008

As we all know, the markets go up, down and sideways. Most of the time, the non-trending portion is taking approximately 70 percent of the trading period and the trending portion, the remaining 30. It seems obvious, then, that, to achieve overall efficiency, one should study in detail the non-trending and trending features of the market.

Let's study in this article, the strategic approach of rectangle trading, through the medium of Dr. Alan Andrews' Median Line, specifically, the steps essential to the rectangle trading process.

As to the rectangle's location within the existing trend -- a vital macro aspect of trading -- the steps are to:

• Establish the previous low or high to determine whether you are in an up or down trend
  • Try to enter only along the trend's direction
  • In case of doubt, don't hesitate to use the bigger time frame to find the precise location of your market price within the bigger time frame wave
  • Clarify whether the current rectangle belongs (or does not belong) to a larger pattern
• Count the major pivots of the existing trend and locate the exact market position within the previous swings; using Elliott waves, we should know:
  • The type of market we are in -- impulsive or corrective pattern
  • The type of wave we are in -- impulsive (W1, W3 and W5) or corrective (W2, W4 or waves A, B and C)
• Evaluate the remaining trend potential until reversal through the use of:
  • Fibonacci count bars (5, 8, 13, 21, 34, 55)
  • Fibonacci ratio analysis, especially 127, 138.2, 150 and 161.2
  • Gann's Square of Nine, especially 45, 90, 135, 180, 225, 270, 315 and 360° (It is important to mention here that, most of the time, the market price enjoys, especially when we are talking rectangle trading, a very strong encircled zone, defined within a single 360° cycle.)
  • Dynamic Gann Levels developed by Don Fisher, where the so-called Level 3 reveals its full importance
  • Gann Angles, where the 45° trend line gives the direction and the other angle's lines serve as support, resistance or price objectives
  • The Gann Percentage Rule based on specific values: 12.5, 25, 33, 37.5, 50, 62.5, 66, 75, 87.5 and 100%

  Tip: It is essential to count the number of rectangles in a prevailing trend in order for the rectangles to be useful in projecting trend termination. It is highly probable that the current rectangle's breakout will continue the trend.

Sometimes, we trade the counter-trend if the Elliott wave 3 is over-extended, lengthy enough (at least 2.00*W1), to allow a profitable W4 retracement. We enter the trade only when the reward / risk ratio is at least 2.5, with an imposed pre-arranged target of 38.2 percent Fib retracement.

Figure 1. Exceptional Trading of Elliott Wave 4

For rectangle internals -- a micro aspect of trading, synergistic with the macro aspect -- the steps are to:

• Analyze carefully the different traits of the rectangle in such a way as to give you a fairly valid projective value for low-risk, high-probability trades (We prefer to use the more appropriate term “projection” rather than “prediction” or “forecast”. The crowd tends to ignore failures in spite of the fact that they are fairly easy to identify because the price doesn't reach the corresponding target trend line once the rectangle is properly validated [4 touches]. The current momentum suddenly shades off, announcing an imminent move in the contrary direction.)
• Track the typical reversal bars; the thrust of the Momentum [10] indicator in synergy with mirror, inside or outside bars is a way to confirm these kinds of reversal situations, as follows:
  • A partial decline (a down-sloping failure) constitutes one of the best indicators for establishing the imminence of an upward breakout, but, we repeat, only if the rectangle is properly validated. The partial decline's bottom will be a higher low, which will automatically project a new intra-rectangle trend capable of attaining the necessary upward momentum and breaking outside the rectangle's upper boundary. A new upward inside rectangle trend can then be drawn. (Note: We've discovered that the False Bar Stochastic, a proprietary tool in eSignal, Advanced GET Edition, is one of the most useful tools for sideways trading. Its advantage is in identifying the inceptive and developing trend out of a reversal.)
  • A partial ascent (an up-sloping failure) constitutes one of the best indicators for establishing the imminence of a downward breakout, but once again, only if the rectangle is properly validated. The partial ascent's top will be a lower high, indicating that the market lost its steam, provoking an intra-rectangle reversal. It will automatically project a new intra-rectangle trend, with its downward trend line capable of attaining the necessary downward momentum and breaking outside the rectangle's lower boundary.
    
    
    Figure 2. Up- and Down-Sloping Failures within Rectangles
    
    
• The nearness of the rectangle to the top or bottom of the entire commodity's lifetime range or stock's yearly price range could affect the trade's probability. Many authors agree that, near the contract's highs, the breakout of rectangles is much more efficient than near its lows.
• The height of the rectangles is a factor, given that tall rectangles break higher than the short ones.
• The width of the rectangles, like the height, is crucial in rectangle trading. We can usually project the rectangle's breakout target at a minimum of one height. The maximum target can rise to several height multiples. We can also determine this probable target by counting the rectangle's bars and applying that number to the target projected value (measure rule).
• Breakouts result in throwbacks and bull traps more than a quarter of the time, with the former occurring more than twice as frequently as the latter. These two features are responsible for most of the losses experienced by aggressive traders; this phenomenon is also known as a false breakout. An experienced trader can avoid these highly risky situations if, while preparing the trade, he / she checks for overhead strong resistance.

  Tip: Defining overhead resistance / support is very important for low-risk, high-probability trades. One should analyze thoroughly all the choices in as detailed a manner as possible, as follows:

  • An old high and low, or previous gap levels, on hourly, daily and weekly charts
  • A single daily floor pivot or a clustered zone with weekly and monthly floor pivots
  • A strong Gann level: 45° trend line, 50% trend line, a percentage retracement, a Level 3 (as defined by the Dynamic Gann Levels method of Don Fisher) or a main value within Gann's Square of Nine
  • A Fibonacci retracement or extension
  • A specific pattern, such as a price consolidation
  
  
• Volume gets heated when the breakout takes off. We normally use this indicator at the low of the chart, together with a volume-moving average of 21 bars. Look for the breakout spike, which will outpace the level of previous ones.

  Tip: Go to a lower time frame when the price approaches the rectangle's trend line (a 2-minute chart, say, if you're trading in a 5-minute time frame or a 5-minute chart if you're trading in a 15-minute time frame). It's like observing the market's movements through a magnifying glass.

The integration, in charts, of rectangles and Dr. Alan Andrews' pitchfork, will greatly increase your trading consistency.

Figure 3. Don't hesitate to draw inner rectangles, which will greatly help in timing the most adequate place for a breakout. If the volume is weak or average, watch for a pullback.

Figure 4. Once again, the synergy between the rectangles and Dr. Alan Andrews' Pitchfork gave excellent results.

How the Rectangle Trade's Morphology, Despite Similarities, Differs from That of Dr. Alan Andrews' Horizontal Pitchfork

Even given obvious similarities, in our experience, there are a few differences in the trading characteristics of these two indicators, as follows:

• The 50% Fib line of the rectangle attracts the price less than the pitchfork's median line.
• The upper / lower boundaries of the rectangle attract the price more intensely than the upper / lower pitchfork's median lines.
• The up / down 100% projected lines of the inceptive rectangle perform better than the pitchfork's warning lines.
• The parallel sliding trend lines drawn on the top of the spike's high / low, just outside of a rectangle, perform at least as well as those of the pitchfork's, or even better.

Most traders are gun shy when considering rectangle trading. Know your market and trade's characteristics. A disciplined trader makes use of an adequate trading plan without any second thoughts, making no exceptions. Trading rigor is the only way to conquer the immense sideways market having a 70% unveiled trading period potential.

Thus, the trader becomes consistent and profitable. And, sure as the sun rises in the morning, the synergy of Dr. Alan Andrews' median line concept will be present.

*This article is a reprinted (and modified) version of an article published in The Technical Analyst with permission from Dr. Mircea Dologa, a Commodity Trading Advisor who founded a new teaching concept for young and experienced traders at www.pitchforktrader.com. He can be contacted at mircdologa@yahoo.com.