Introduction to the Stock Market_9. Chart patterns_ Flags and pennants

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Lesson 9: Chart patterns. Flags and pennants

Definition
A flag is a technical charting pattern that looks like a flag on a flagpole and suggests
a continuation of the current trend. Flags are areas of tight consolidation after a
sharp movement in price and typically consist of between 5 and 20 price bars. The
bottom of the flag should not be lower than the midpoint of the flagpole that preceded
it. Likewise, "pennant" formations are usually treated like flag formations because
they are very similar in appearance, tend to show up at the same place in an existing
trend, and have the same volume and measuring criteria.

Breakdown
Flags and pennants are among the most reliable continuation patterns that traders
use. The only difference between the two patterns is that a flag resembles a
parallelogram (or rectangle) marked by two parallel trend lines that tend to slope
against the prevailing trend. The pennant, however, is identified by two converging
trendlines and more horizontal which resembles a small symmetrical triangle. The
important thing to remember is that they are both characterized by diminishing trade
volume, and though different, the measuring implications are the same for both
patterns as demonstrated in the above illustration.
Let’s have a detailed look at an example.

This is what a flag looks like. It’s made of two parts: the pole, and the flag itself.
This sharp rise here is the pole, the markets are rising sharply, then we get a
consolidation or pause. This pause comes in the form of a flag, which is a small
retracement. This basically means that the bulls are ready to buy at a slightly lower
price, because they believe the rally should keep on, there is more potential in the
stock.

We want this to break out and go up. We will not trade this short. This is a
continuation pattern.

Same with a downtrend. The prices are falling quite sharply, that would be the pole
of our flag, and retracing a bit on the up side, giving us our flag. We can mark two
trendlines moving upwards, and basically the break of the trendline would mean that
the stock is breaking down and should continue falling.

Why does a bull or bear flag happen?

Let’s say a stock beat the street, people were expecting half a billion dollars of
revenues, and they made a billion dollars. It beat the expectations by a huge margin,
and the prices will swiftly move up. When this happens, we will then get a pause,
meaning the buyers drying up, evaluating the situation, and also the sellers waiting
on the sidelines to see what happens. You get the profit brokers who have made a
certain profit, exiting, the day traders also exiting, and you get a small retracement.
You’re getting a lot of buying pressure in this move down, people are missing or
adding to the up move by buying on these certain points. It shows that the bulls are
ready to buy at a slightly lower price, still after moving so high up.

This pattern does pretty well when you pull it off, especially on the major trades.
Do try and trade this pattern on a slightly higher frame like the 30 min or 60 min
frame, because on the lower time frames, it becomes a bit difficult to identify,
because there are a lot of bars, and every retracement looks like a flag.
You should not get a lot of patterns on a chart, that just means it won’t work, you
don’t have an edge.

Trading Considerations

The pause period is often followed by another sharp rise. This is where the trading
opportunity comes in. Once the flag pole and a flag or pennant have formed, traders
watch for the price to breakout above the upper flag/pennant trendline. When this
occurs, enter a long trade.
The above pattern is bullish, because the pattern started with a sharp rally. There are
also bearish patterns, where the price drops sharply then forms the flag or pennant.

With this pattern, watch for the price to break below the flag/pennant.

If a short trade is taken on the downside breakout, place a stop loss above the high
of the flag/pennant (not the flag pole).
If a long trade is initiated on an upside breakout, place a stop loss below the low of
the flag or pennant (not the flag pole).
Price Target
The concept behind the flag and pennant patterns is that the momentum seen during
the flag pole phase could continue once the pattern completes. Therefore, measure
the size of the flag pole, then add that length to the bottom of the flag/pennant for

bullish patterns.
For bearish patterns, subtract the length of the flag pole from the top of the
flag/pennant.
Conclusion
Flags and pennants occur in both uptrends and downtrends. Focus on trading
upside breakouts from bullish patterns during uptrends. While a downside
breakout may indicate the price could move lower for a time, going short during an
uptrend is a less reliable trade.

Similarly, if an asset is trending lower, focus on trading downside breakouts from
bearish patterns.

Since flag poles can be quite large, and the size of the flag/pennant quite small,
these types of patterns produce. The reward or profit target is based on the strong
movement of the flag pole. The stop loss, on the other hand, is based on the small
area that forms the flag/pennant. Reward potential on these trades often outweighs
risk by a factor of three, or more.

Stay with us for the next lesson will fully explain how to trade flags and pennants.

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