Among a wide variety of chart formations, Flag Pattern is one of the most widely used in the technical analysis. When a trend moves sharply, and then consolidates or gains momentum before breaking through a significant technical or psychological level, the price chart looks like a flag or pennant. It has a long upside or downside flagpole representing an acceleration of the price action and an asymmetric triangle pointing to the corrective and consolidation period.
In other words, every trend can be divided into three stages where the first is a strong and fast movement, second is a bounce back and third is a breakthrough in the same direction as the first one. The only difference is that the second stage might have several swings in both directions, while the sequence of higher lows and lower highs remains. Therefore, during the second corrective stage, two trend lines can be drawn, forming a triangle or pennant.
What is a Flag Pattern?
A Flag Pattern has two components. The flagpole usually has a short-term spike of an asset price which looks like a stick on the chart. The flag itself traditionally has a longer period as the market needs to re-gain the momentum to continue the previous action.
Sometimes the delay is related to a strong technical resistance or support level as buyers or sellers need to absorb a certain volume of postponed orders placed at around that handle. In other cases, the market players need a confirmation of a fundamental driver, which caused the previous sharp swing (flagpole). Once the data confirmed, the price action resumes in the same direction, and the resistance level is getting breached.
How does a flag pattern look like?Below is an example of a flag chart:
Types of Flag Pattern
Depending on the direction of the initial price action, Flag Pattern can be two types:
The Bull Flag pattern is on the price chart:
The Bear Flag pattern is on the price chart:
The form of the corrective stage can also determine the kind of the flag itself. A wedge or pennant usually has a triangle form, while other flags can have parallel trend lines during the correction.
There is also a so-called checkered flag pattern. It is composed of different parts of the formations described above. The main explanation is related to the fact that financial markets are not so straightforward as some of the mathematical formulas can describe. So trendlines and resistance/support levels can be uneven. This is why mixed combinations of different patterns appear on price charts. Here is an example.
Trading volume in Flag Pattern
To assess the likelihood of the breakout in the same direction as the previous action and confirm the efficiency of the flag chart pattern, technical analysts add trading volume to the price chart. One of the main requirements for the formations sustainability is that the trading volume usually spikes during the explosive action and declines in consolidation phase. So to make sure that the breakout happened, traders could monitor the trading volume of an asset.The confirmation of the trading volume pattern will look like this:
From the chart above traders can see how the GBP/USD currency pair was surging together with the spike in trading volume. However, when the flag was forming, and the pair was consolidating, the trading volume dropped. Once the breakthrough happened, the trading volume increased again.
How to use a Flag Pattern?
The technical analysis suggests that the forex flag pattern is a formation pointing to a continuation of the recent trend. Thus if the price action was headed North before the flag formed, traders should consider opening long positions. Otherwise, if the flag pattern headed south, then traders might open short positions for the asset.
The most crucial step here is to determine whether the breakout happened or not. First of all, forex traders should not consider whipsaws and candlesticks’ shadows as the breakout price. Any resistance or support is considered breached only when the next bar’s close rate is above or below it. It would be even better to have at least a couple of close rates, which breakout the resistance level consequently to consider it breached.
Determining entry levels
There are two approaches to identify the best entry price with flags. The first one is conservative and it’s based on the breakout trading strategy. For instance, after the resistance level determined by at least two tests of the trendline, traders can set a postponed buy-limit order. The open will be triggered automatically when the price reaches the pre-set level. In this case, it’s recommended to set if-done orders and delete them if the breakout did not happen.
The second approach is more aggressive in terms of early entry. If the price action points to a third or a fourth test of the support trendline, which is the base of the triangle, then traders could open the deal before the breakthrough happened. The risk is that the price might not confirm the previous direction, and bounce deeper with the counter-trend action. This is why a tight stop-loss is required. However, if the flag formation shoots out, potential profits can be significantly larger.
Setting stop-loss orders
In order to protect the stop-loss order from an unwished triggering, forex traders should hide it below the support or resistance level, adding a certain number of pips for a possible whipsaw. The depth of the stop-loss has to be determined depending on the asset, average volatility and current trading volume. For example, the optimal distance for a stop-loss for EUR/USD is in the range of 10-15 pips below the support threshold. For more volatile currency pairs like GBP/JPY, the distance should be enlarged to 35-40 pips as this kind of asset class can easily trigger the order, reverse and go in the right direction. Thus, a potentially profitable position could turn into a loss instead. Besides, traders should keep in mind their individual trading strategies and money management rules when setting a stop-loss. It is also important to keep an effective profit/loss ratio.
Setting take-profit orders
Targets depend on several factors such as the asset class and its volatility, a potential distance of the current trend on larger time frames and trend’s strength. For a conservative type of trading strategy, it would be better to use a pre-set take-profit order with a certain number of pips. Some traders say take what’s yours and go away. It’s also understood that 20 pips for EUR/USD could mean 50 pips for GBP/JPY. There is also an option to use a trailing stop to maximise the profit from trading in the financial markets. When setting targets, traders also should keep in mind the previous action. So, for example, if the initial spike was for 100 pips and after the consolidation and breakout, the currency pair could easily go for another 100 pips. Nevertheless, taking profit manually is not a mistake in any case.
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Flag chart pattern examples
This section shows how the flag pattern forex trading can be profitable, how to find the best entry points, where stop-loss and take-profit orders should be set, and what’s the best condition to exit the trade.
Breakout long position
The four-hourly chart below shows USD/CAD during the sharp uptrend on August 20, 2019. The explosive action formed a flagpole, while consolidation led to the flag pattern. After the bullish breakout, a long position was opened. The stop-loss order was hidden 15 pips before the recent low. The profit was taken when the bullish momentum got exhausted.
Short after the breakthrough
USD/ZAR was declining sharply on the hourly chart below. After breaking the support line of the flag pattern, the pair accelerated the downtrend. The deal has the same consequence as the previous example but with mirrored conditions.
Technical indicators to use with flag patterns
Technical indicators are useful tools to confirm or deny any chart pattern and the stock flag is not an exception. For better efficiency, several combinations of technical indicators can be applied to the price chart. For example, momentum indicators can act as the key instruments to determine the trend’s direction and strength, while fast and sensitive oscillators could point out overbought and oversold conditions. Moving averages are also important as they show when the rate could bounce off a certain level or when the retracement is getting too deep to proceed with the previous trend. Below are several examples of profitable trading using technical indicators together with flags.
EMA, MACD and RSI confirmed the flag
The price of gold was trying to regain the momentum in a consolidative phase inside the pennant. MACD lines stayed above zero, pointing to a sustainable bullish momentum. The Relative Strength Index did not cross the overbought threshold from above, confirming the overall direction of the current trend. The latest bounce was limited by 21-bars exponential moving average, which acted as the support and triggered a long position. After the breakthrough, the price of gold continued the rally.
TSI and higher lows provide a buy-signal
The S&P 500 index had a two-hours spike of the rate, which was followed by a 27-hours consolidation. The question about further trend’s direction was still open when the index charted the latest red candlestick inside the flag. However, the sequence of higher lows was confirmed by the Trues Strength Index, which remained positive despite a certain retracement. Longs were triggered on the open of the next candlestick before the resistance level was breached. The uptrend continued.
The Flag Pattern is a widely-used continuation formation, which helps forex traders to find best entry levels, signal a perfect moment to open a trading deal, set protective orders and maximize potential profits. Several types of flags point to different market conditions, while breakout levels are often informative and clear. In order to increase the efficiency of a trading system, and lower the number of false trading signals, forex traders can use additional technical indicators. Combinations of tools in the technical analysis and the right choice of the timeframe together with proper money management can provide a decent profit from forex trading. However, traders should keep in mind the changing nature of the financial markets and always take into account possible counter-trend action.