Technically Speaking ... (A lesson In Trading Flag Formations) Part 1

So you wanna be a flag trader eh?? Well, I can’t say that I blame you. Flag breakouts are some of the most powerful moves a stock can make. Flag formations are relatively easy to spot, and relatively easy to trade as well. You may be wondering, however, just what exactly IS a flag formation?In this series of articles, I will attempt to describe a flag formation. Later on in parts 2 and 3 in the series I will get into some more of the technical aspects of flag trading.

So what is a flag? Well according to Magee and Edward’s classic textbook of technical analysis "Technical Analysis of Stock Trends", a flag formation is described as:

" a small, compact parallelogram of price fluctuations, or tilted rectangle, which slopes back moderately against the prevailing trend." I would add "which forms after a sharp, almost vertical movement in price"

In an uptrend, a flag will look like a flag. The "flagpole" would be defined by one or two days of rapid advance (in an uptrend). The "flag" portion forms after the advance has halted. A good example of a flag was the formation formed by Broadvision (BVSN) in June of this year:

There are two key points in this chart. First of all, the flag that formed after the sharp move up in the first few days of June FORMED AS THE VOLUME WAS DECREASING. This is a key point in determining if a flag is really a flag. The FLAG SHOULD FORM ON DECREASING VOLUME... Let me say it again, its that important: THE FLAG SHOULD FORM ON DECREASING VOLUME...

A second kind of "flag" is the "pennant". The pennant is basically the same as the flag, only instead of a "parallelogram" forming the flag portion, a consolidating triangle forms. This type of chart looks like a pointed flag, or "pennant". Pennants have been very common in recent years. Cygnus, Inc (CYGN) formed a nice pennant in late June of this year:

Again, notice the increase in volume as the stock moved from $9 to $12 in mid- June, then the sharp decrease in volume as the pennant formed and finally the increase in volume as the stock broke upward sharply.

Flags can form in downtrends as well. The difference is that the flag or pennant will appear to be "upside down". This is because the flag or pennant portion will form after a sharp move down, which forms in inverted "flagpole". 1-800 Contacts (CTAC) formed an inverted flag in late September and early October of this year:

Again, notice the strong volume on the flag pole on October 28 and 29, and then the decreasing volume as the pennant formed through October 6th. Finally, the stock exploded downward from $45 on October 7th, then gapped down to $27 on the 10th before reversing. Shorting this flag at $45 and covering on the gap down two days later would have netted the savvy flagtrader 40%. Not bad for a coupla days work!

It is important to note that MOST flags tend to break out in the direction of the prevailing trend. This is important to note. The strongest flags to buy "long" are upright flags in stocks that are trending up. Similarly, the best flags to short are upside down flags in strong downtrends.

Have we got your interest yet? If one this is obvious from these charts, its that alot of money can be made if one is savvy enough to identify and trade a flag breakout. In future articles in this series, we will discuss trading tactics for timing a flag breakout and maximizing your return. We’ll also take a look at how other technical indicators can help provide clues to which flags will fail. Finally, I discuss some of the warning signs to watch out for, when it looks like a flag is breaking down instead of breaking "up".


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