A flag is defined in most major textbooks as a parallelogram that lines up with the current trend. In almost all cases, flags show the chartist a very short pause in the trading activity of the prevailing trend. Flags will last only a few weeks, while pennants though quite similar, will often represent as few as seven to 10 trading days. A pennant is often more symmetrical in design and somewhat horizontal in shape. History has shown us that the direction of the trend continues after the formation of the pennant has been completed. Both are examples of continuation patterns.
Tutorial: Analyzing Chart Patterns
If you were to sit down and study a number of charts today, you would be able to see quite a number of flags and pennants. The beauty of hindsight is that it is always 20/20. The key is to be able to spot the formation of the patterns as they are developing.
Imagine for purposes of this study, a dramatic day of trading that produces a long straight-line price bar that resembles a flagpole. In order for the market to catch up to this bold move, the next few days of trading will form a flag or a pennant, as the investors settle in to this new price range. If these next few days witness the stock trading in a narrow range with the highs and lows in a similar price pattern, then a Pennant is formed. If the highs and lows are falling off slightly in the opposite direction of the prevailing trend, then a flag is formed. A key to the recognition of both these patterns is that the volume will diminish dramatically.
|Chart Created with Tradestation|
You can see in this chart of Nortel Networks of Jan 2000 that a flag was formed over a six-day period followed by the continuation of the prevailing trend. The volume, although not shown in this example, diminished each day and did not pick up again until the next sharp upward movement of the stock on the seventh day from the initial development of the flagpole.
It is important to understand how we measure the flags and pennants. If we are to look closely at the "flagpole," the sharp increase or decrease in price action during one trading day, the next week or two will see the trading action fall off, creating lower lows and lower highs, until the next major move in the prevailing trend. It is understood that the trading action, as the flag is developed, will give back almost everything the flagpole acquired on that one day of the sharp increase or decrease.
With respect to flags and pennants in a downtrending market, the time it takes to develop will be dramatically shorter as investors tend to panic sell. One would merely have to chart the dotcoms during their crash to witness this statement.
|(Chart Created with Tradestation) Click on chart for larger version|
The Bottom Line
Both flags and pennants are preceded by a flagpole, one day of dramatic trading with heavy volume. They last a period of one to three weeks in time and the prevailing trend then continues. Because the setup time is so short, you will only be able to witness flags and pennants in daily charting.