What Is a Flag?
In the context of technical analysis, a flag is a price pattern that, in a shorter time frame, moves counter to the prevailing price trend observed in a longer time frame on a price chart. It is named because of the way it reminds the viewer of a flag on a flagpole.
The flag pattern is used to identify the possible continuation of a previous trend from a point at which price has drifted against that same trend. Should the trend resume, the price increase could be rapid, making the timing of a trade advantageous by noticing the flag pattern.
- A flag pattern, in technical analysis, is a price chart characterized by a sharp countertrend (the flag) succeeding a short-lived trend (the flag pole).
- Flag patterns are accompanied by representative volume indicators as well as price action.
- Flag patterns signify trend reversals or breakouts after a period of consolidation.
How a Flag Pattern Works
Flags are areas of tight consolidation in price action showing a counter-trend move that follows directly after a sharp directional movement in price. The pattern typically consists of between five and twenty price bars. Flag patterns can be either upward trending (bullish flag) or downward trending (bearish flag). The bottom of the flag should not exceed the midpoint of the flagpole that preceded it. Flag patterns have five main characteristics:
- The preceding trend
- The consolidation channel
- The volume pattern
- A breakout
- A confirmation where price moves in the same direction as the breakout
Bullish and bearish patterns have similar structures but differ in trend direction and subtle differences in volume pattern. The bullish volume pattern increases in the preceding trend and declines in the consolidation. By contrast, a bearish volume pattern increases first and then tends to hold level since bearish trends tend to increase in volume as time progresses.
A flag's pattern is also characterized by parallel markers over the consolidation area. If lines converge, the patterns are referred to as a wedge or pennant pattern. These patterns are among the most reliable continuation patterns that traders use because they generate a setup for entering an existing trend that is ready to continue. These formations are all similar and tend to show up in similar situations in an existing trend.
The patterns also follow the same volume and breakout patterns. The patterns are characterized by diminishing trade volume after an initial increase. This implies that the traders pushing the prevailing trend have less urgency to continue their buying or selling during the consolidation period, thus setting up the possibility that new traders and investors will take up the trend with enthusiasm, driving prices higher at a pace quicker than usual.
Flag Pattern Examples
In this example of a bullish flag pattern, the price action rises during the initial trend move and then declines through the consolidation area. The breakout may not always have a high volume surge, but analysts and traders prefer to see one because it implies that investors and other traders have entered the stock in a new wave of enthusiasm.
In a bearish flag pattern, the volume does not always decline during the consolidation. The reason for this is that bearish, downward trending price moves are usually driven by investor fear and anxiety over falling prices. The further prices fall, the greater the urgency remaining investors feel to tack action. Thus these moves are characterized by higher than average (and increasing) volume patterns. When the price pauses its downward march, the increasing volume may not decline, but rather hold at a level, implying a pause in the anxiety levels. Because volume levels are already elevated, the downward breakout may not be as pronounced as in the upward breakout in a bullish pattern.
How to Trade a Flag Pattern
Using the dynamics of the flag pattern, a trader can establish a strategy for trading such patterns by merely identifying three key points: entry, stop loss and profit target.
- Entry: Even though flags suggest a continuation of the current trend, it is prudent to wait for the initial breakout to avoid a false signal. Traders typically expect to enter a flag on the day after the price has broken and closed above (long position) the upper parallel trend line. In a bearish pattern, the day after the price has closed below (short position) the lower parallel trend line.
- Stop Loss: Traders typically expect to use the opposite side the flag pattern as a stop-loss point. For example, if the upper trend line of the pattern is at $55 per share, and the lower trend line of the pattern is at $51 per share, then some price level below $51 per share would be a logical place to set the stop-loss order for a long position.
- Profit Target: Conservative traders may want to use the difference, measured in price, between the flag pattern’s parallel trend lines to set a profit target. For instance, if there is a $4.00 difference and the breakout entry point is $55, the trader would place a profit target at $59. A more optimistic approach would be to measure the distance in dollar terms between the pattern’s high and the base of the flagpole to set a profit target. For example, if the lowest price of the flagpole is $40, and the top of the flagpole is $65, and if the breakout entry point were $55, then the profit target a trader might expect to see achieved would be $80 ($55 plus $25).
In addition to these three key prices, traders should pay close attention to position size choices and overall market trends to maximize success in using flag patterns to guide trading strategies.