The flag pattern can be very easily explained by the sentiment that is sometimes witnessed around Independence Day or Republic Day. These days - when flags are dusted off and unfurled with much pride, respect and enthusiasm - see people rekindle their sense of patriotism. Everyone appears more patriotic during a flag hoisting ceremony.
The flag pattern in technical trading - according to traders - has a similar effect on stock prices. Upon the appearance of a Flag Pattern, traders usually anticipate that stock prices will return to a previous trajectory… one that they had veered away from in the short term. For example, if stock prices were rising before the appearance of a flag pattern, traders expect that the stock prices will make a sharp about-turn from their temporary downward movement and swing upwards again.
The Flag Pattern is formed on a stock graph by a stock price pattern that in the short term, reverses the trend that is dominant in the long term.
The dominant trend, or the preceding trend, is referred to as the flag pole and the chunk that marks the price reversal is referred to as the flag.
Flags Patterns may be bullish, that is to say - they may indicate a potential impending price increase….or they may be bearish, signaling a potential impending stock price decrease.
For a price movement to qualify as a Flag Pattern, it must have a certain set of must-have. Do take a note of these and watch for them if you think you see a Flag Pattern.
Must-have number 1:
You need at anywhere between 5 and 20 periods - or trading days - to have sufficient highs and lows in order to chart a Flag Pattern reliably. The higher the number of periods that line up to form a Flag Pattern, the higher the likelihood of it panning out as predicted.
Must-have number 2:
Other indicators, especially Volume, must support the prediction pegged on the Flag Pattern. In the Bearish Flag Pattern, Volume increases during the preceding trend and then plateaus out during the reversal period, also known as the consolidation period.
In the Bullish Flag Pattern, Volume increases during the preceding trend and decreases during the consolidation period.
Must-have number 3:
The lowest point of the Flag should not have crossed the centre point of the Flagpole. This is true for both bullish as well as bearish Flags.
Must-have number 4:
During the period of consolidation the trader will usually check for whether the candlesticks line up such that the highs and lows form parallel lines. If instead of forming parallel lines, the highs and lows line up to form a wedge (or pennant) shape, the trader will make considerations and predictions based on wedge or pennant patterns, which are very similar. You can know more about these too in dedicated podcasts about rising and falling wedges and in this podcast's counterpart podcast about pennant patterns.
Coming back to must have number 5 for Flag Pattern:
A breakaway movement is absolutely essential for traders to put their money on a Flag Pattern prediction.A breakaway movement is basically a stock price movement that is a reverse of the current trajectory. Traders view this as the impending end of the consolidation period. They predict that the reversal is about to be reversed and the preceding pattern is about to become dominant again.
Must-have number 6:
Even if the stock price graph has all the above must-haves on point, in the absence of must-have number 6, traders will usually question the efficacy of any predictions based on the Flag Pattern that they have identified. And must-have number 6 is very simply - a confirmation.
This confirmation comes by way of the stock price actually making the movement predicted. Is the temporary reversal indeed bring reversed, to put the stock price back on the preceding trajectory? If yes, traders will usually put their money on the Flag-Pattern-prompted prediction.
Traders also use Flag Patterns to ascertain where they want to place their entry, stop loss and target price. The parallel lines formed during the consolidation period hog all the limelight at this stage.
For their entry price, in a Bullish Flag Pattern, traders will usually choose a point just above the upper parallel line formed during the consolidation period. The trader will take a long position or in other words will buy. In a Bearish Flag Pattern, traders will usually enter just below the lower parallel line formed during the consolidation period. The trader will take a long position or in other words will buy.
For their stop loss, traders choose a point slightly below the opposite side of the Flag.
For their target price traders have two options. Option 1: consider the difference between the prices at the upper and lower parallel lines. Add that to the current price and viola you have your target price.
Option 2: consider the difference between the prices at the upper parallel line of the flag and the base of the flagpole. Add that to the current price and viola you have your target price.
Enthusiasm and cautiousness must be balanced when trading on the stock market. Never let the excitement of spotting a Flag Pattern tempt you to overlook the list of must-have that we discussed earlier in today's podcast. Lastly only trade with funds that you have set aside given that the stock market is both lucrative as well as risky.