How Good Is Your Chart Pattern Recognition Ability
One of the first experiences most traders go though when beginning technical analysis study is chart pattern recognition. One of the first patterns most traders learn is the flag pattern. This is a simple continuation pattern that forms after a strong trending market. The pattern is a congestion pattern that is very similar to triangle and wedge patterns.
The main difference between these patterns and the flag pattern is slope of the lower support and the upper resistance area. There is no convergence between the two trend lines and they both run parallel to each other unlike the triangle pattern which gets tighter as both trend lines converge towards each other as the triangle pattern progresses.
You can see in this example both the bull flag and the bear flag. Both have upper support and resistance areas that are completely parallel to each other. The flag takes a bit less time to develop than the triangle pattern because the level of volatility doesn’t decrease in a flag formation nearly as much as it does in the triangle formation.
In this example you can see the triangle formation clearly. Notice how both the upper and the lower trend lines converge towards each other as the flag formation continues developing. The upside of the triangle formation is less risk due to extended tightening of the trading range. The downside of the flag is the extended time it takes for the triangle formation to fully form. The flag formation typically forms in less than a month but has more volatility and therefore more risk associated with it.
The flag pattern is a classic continuation pattern that forms after the market has begun trending in one particular direction. Don’t look for flags immediately after a market reversal occurred, a stable trend should be underway before a flag formation takes place. Keep in mind that a continuation pattern is a pause in the existing trend not a change in the direction of the trend. Notice in this particular example how the stocks main trend is clearly identified before the formation of the flag begins.
One the flag formation completes the stock should exhibit strong volatility and resume movement in the direction of the trend. Do not take signals counter to the trend in these scenarios no matter how appealing they look visually. The flag pattern is a pure continuation pattern; therefore all signals have to be taken in the direction of the main trend.
Here is another example of Google forming a bullish flag pattern after a strong upwards move that lasted one straight month. The flag pattern should take about one third or one quarter of the time to form compared to the trend preceding the formation. One of the benefits of trading flag formations is having to wait less time than formations such as triangles and wedge patterns.
When stocks breakout from flag patterns, they should demonstrate increase in volatility and momentum back in the direction of the trend. Sometimes you will have other events such as news or other important announcements that coincide with the breakout of the flag pattern. The stock should begin moving similarly to how it moved prior to entering the flag pattern in the first place. You want to money flowing back into the stock with very little movement going against the main trend.
The bearish flag pattern is exactly the opposite of the bullish flag pattern. The trend has to move down for a substantial amount of time prior to the formation of the flag pattern. Once the flag begins to develop you should see a substantial decrease in volatility and momentum compared to the trend prior to the formation. Notice how Intel drops one quarter of the stock’s price prior to entering a flag pattern in this example.
The bearish flag formation tends to form a bit faster than the bullish flag pattern. Most chart patterns react this way so this is not a big surprise. You should see a good breakdown following the completion of the flag pattern in both cases. Gaps towards the downside and increase in volume are not unusual occurrences with this chart pattern.
When trading either the bullish flag or the bearish flag you should keep in mind that this formation is a brief pause in the current trend and not a trend reversal. You should also remember that flags tend to develop quicker than triangles and wedges because flags don’t develop price consolidations or narrowing of the trading range. This will save you some time but will increase the risk of your position due to more volatility when you enter the trade. It’s a tradeoff between less time and more risk, just like most things in life. For more on this topic, please go to: Opening Range Breakout and Technical Analysis Patterns – Continuation Patterns
All the best,
By Roger Scott