Ah, that makes sense. The red-zone movement still goes in the direction you press from the position of the head, but, right, the transformation positions don't map easily that way, sometimes jumping diagonally or whatnot. It's almost more like a gallery of position options would be a better way for the player to think about it. I wonder, if you went back to arrows for positioning, if it would help to have left/right indicators appear when choosing the position. It could provide a signal to the player to context switch from direct control of the piece to something more like "scrolling" through the options.
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Starting with up/down might work, since it isn't used in bulk movement, and most of the time you need a transformation to extend your vertical reach. The "no neutral position" issue might be reduced if the transformation starts at some half step position according to common center of mass, rather than maximally overlapping or most recently used, so that there's nearly always least one arrow involved in choosing the position; something to try.
Another scheme: You might choose a block (with arrows) and then use the arrow to draw the new shape from there (similar to red zone), eliminating the need to look back to the catalog to pick a number. Seems more natural, but likely too many keystrokes, and going from choosing a starting point to drawing is awkward. (Edit: This would be nice for touchscreens!)
You probably wouldn't have to worry too much about which is the starting position option with either the up/down or left/right, so long as you wrap the scroll like you already do with the current scheme. I like your up/down thought and reasoning, btw.
The alt scheme you proposed also has the benefit of allowing a player to play single-handed and would map to a controller well.
I will say that I didn't mind the quick select of the number keys. It actually felt pretty natural until I was going to 7 and 8. Two keyboard rows (e.g., 1234 and QWER) might be a nice option if you kept that scheme.