Technically Speaking (A lesson in flag trading, Part II)

So now you know what a flag is... and maybe you’ve even found a few of them.. Now what? Finding flag formations and making money from them are two different ballgames. In this articles, I’ll provide a few pointers to maximize your flag trading profits and avoid losses.

Once you’ve identified a potential flag or pennant, the next step is to WAIT.... Like so many other aspects of the stock market, trading a flag breakout requires patience. The reason for this is simple: not all flags break upward, some actually break down. The easiest method for buying into a flag play is to use a stop buy transaction. Stop’s are familiar to most stock traders, most often in the form of a "stop loss sell", which is a sell order that automatically triggers, once a certain price has been reached. This type of order offers some protection against unlimited losses. A "stop buy" order works in much the same way, only in reverse. A "stop buy" order triggers a buy of an equity if it reaches a certain higher price. As long as the stock trades below the stop buy price, the order is not executed. The minute the stock reaches the stop price, a buy order triggers. This particular method of buying works extremely well for buying flag breakouts. Remember, a flag or a pennant is a series of falling or tightening daily ranges in a stock’s daily price chart. For this reason, a stop buy can be easily entered at the "breakout" point. Lets take a look at PlugPower (PLUG), which turned out to be one of the hottest stocks of late 1999 and early 2000

PLUG formed a very nice pennant formation from January 5th to January 14th, 2000. As the pennant was taking shape, it was easy to visualize a down-sloping line from the January 7th top of the flagpole to the breakout on January 18th. A stop buy order in this case would have been placed as 1/8th to 1/4th point above the down-sloping line. On January 18th, the buy stop order would have triggered at about $60 1/8. PLUG would peak at well over $150 within 4 trading days.

While entering a flag breakout can be quite simple, deciding when to sell can be a bit trickier. It is helpful to have a predetermined "sell price" in mind, when entering a trade. For flag breakouts, the minimum price target expected can be determined by the height of the flag, before it breaks out. The general rule is that the "flag flies at half mast". This simply means that a flag breakout should carry at least as far as the distance between the base where the "flagpole" originally broke out of , and the pinnacle of the flag itself. Taking a look at the example of Interworld (INTW) in late December of 1999, we can see a good example:

INTW formed a pennant with a pinnacle at $77 and a base at around $63 in late December. The difference between the pinnacle and the base (77-63 = 14) suggested a move up to at least $91 (77 + 14 = 91). Interesting, INTW peaked out at around $94 intraday on January 31st, 1999 before reversing. If one had set a sell stop at $91, this trade would have executed perfectly.

The measuring formula described above is a conservative way to capture the profits from a sharp flag breakout. In some cases, however, a flag breakout will carry much higher than the minimum target determined by the measuring formula. The easiest way to maximize profits in this case, is to use a series of trailing stops, each placed at 1/8 of a point below the previous day’s closing price. In most cases, a flag breakout will continue in a relatively vertical pattern for one to seven days. It is typical that as soon as the stock trades into the "red", that is, below the closing price from the previous day, the breakout is over. Again, this method is not foolproof, but I have found it to be quite effective at capturing a large portion of gains from a flag breakout, while minimizing the chances of losing the gains to a sharp pullback.
In the next article in this series, I will talk about using technical analysis to avoid some typical flag trading pitfalls. Be sure to stop back in for that article.