It has been a few months since I have discussed the procedure for how I treat any given trading strategy, today I am going to highlight how I trade flag patterns.

A flag pattern is a chart pattern that illustrates the look of a flag. You have a sharp move in prices, which is referred to as the “flag pole” followed by the flag itself. A flag can be bullish or bearish, depending on the context of the underlying trend and the shape that follows. Naturally, bear flags occur in bear trends and bull flags occur in bull trends. Both are continuation patterns which suggest that once confirmed, prices will continue in the direction of the underlying trend.

Below is a chart to give you both examples.

ICE- Taking on the shape of a Bear Flag

BIIB- Shape and confirmation of a bull flag.

Now I have seen some serious randomness when it comes to other peoples interpretations of flags…but as I like to say, “beauty is in the eye of the beholder.” Just make sure it looks like a flag, and follows the description I gave above. In all, this pattern should only take a few weeks to form at the most.

There are four things to plan around trading flags.

The Shape

Make sure what you are seeing is a flag, and not just you making things up. Seeing the shape also includes finding these patterns in the context of the right trend. For example, how effective would the shape of a bull flag be in a downard trend? Would this be considered a reversal? I leave those alone.

The Anticipation

If you choose to anticipate a breakout, do it. I have told you many times to take half your position in anticipation, and add the rest on the confirmation. If I could choose, I would do so near a support/resistance level, so I could exit quickly if it failed.

The Confirmation

When the breakout comes, it is good to see volume levels near at least a 10 day average, preferably higher. A confirmation is a close above resistance (bull flag) or a close below support (bear flag) with good volume. Using ICE as an example, a confirmation would be a close below $87. This is where you take a trade or add to an anticipatory position.

The Re-Test

After the breakout, prices are likely to test old resistance as new support and vice versa. If you hold through this, your mental stop should be the prior support/resistance level in which prices broke out. If this level fails, so does the trade. At that point you close. Some traders wait for this as an entry point. However, the risk is that this point is not guaranteed to come. The best flags skip this step.

When planning the trade, measure the height of the pattern from high to low. Using ICE as an example, the flag measures from $106-$80 ($26 points). The objective should be met over the length of time that it took to form the pattern, give or take. With ICE, this pattern took 7 trading days. However, it is important to note that most of that move was an anomaly. It was something that is not the norm (the price action on the 9th and 10th). Be careful when dealing with expectations that could be considered unreasonable.

Posted in Categories: Contributor, External Research, Stocks.