Jason Mitchell Articles
Constructing and Trading Flag Patterns - Part 1
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In this series of articles we take a look at the flag pattern and will detail the methods we use of detecting, analysing and constructing the pattern. We will also discuss a few ways in which to find these patterns and how these opportunities may differ from the text book to real life examples.

When we are trading shorter-term precision patterns, we prefer the use of bar charts. We find these patterns are easier to see on a bar chart and this is about the only time we prefer them over candles. We use candlesticks in our management of the trade once opened.

Special Note on Flag Patterns

The flag pattern is a short-term technique, which we believe is generally not suitable to novice traders. These short-term techniques require a higher level of discipline than many new traders possess in their first few years. Decisions on these often need to be made instantly. If you have found yourself procrastinating on a trend trade or slower investment then shorter term trades such as flag patterns may not be for you.

When the pattern works it looks like the easiest trade in the world, and maybe it is. But when they do not work - this is where people can get in to big trouble as they become much more difficult to manage. Many new traders do not enter a contingent plan for this occurrence and it would seem very few people discuss how they manage the situation of a pattern that broke out but did not hit its target. We will do this in this series.

What is a flag pattern?

A flag pattern is specifically a shorter term trading pattern based on momentum and an excited crowd. The way in which it appears gives it its name and the following diagram shows very basically how the flag pattern looks. It does have fairly specific criteria regarding its construction and these are covered in the next section.

Flag Pattern
For now we basically want to show that the pattern is characterised by a very strong sudden burst of interest followed by a small retracement. These two occurrences are the setup. The excitement is characterised by the long flag pole and the small retracement creates the flag. The long flag pole is often on much higher volume than the surrounding periods and the retracement is on much lower volume relative to the flag pole.

The accepted psychology behind this is generally a large number of new buyers have entered the market and the excitement takes out the waiting sellers and they push prices up. The move has taken some shareholders by surprise and others may be happy to move in and take the price being offered while it is available. As these profit takers or shareholders move in to sell and buyers no longer have to chase prices, the price pulls back slightly. This creates the flag itself.

As the profit takers dry up however and the buyers remain the price generally resumes a strong upwards move. It is amazing how many times these patterns occur JUST PRIOR to announcements and in fact I jokingly refer to this pattern as using insider trading. (Our real time trade example at the time of writing this article was an example - MCR).

Now that we know a little about the psychology behind the move we will have a better understanding of what it is we are trading. On this note - we are not trading the stock but the brief amount of excitement in the crowd.

Construction Rules

The construction rules that I cover here are those accepted by the majority of traders. These rules are fairly strict in this pattern and these have been created by the traders who go before us based on their mistakes. If you do not follow these rules then expect to get burnt with this pattern. In this series of articles we show an example of a flag trade that goes against expectations as well as a poorly drawn flag pattern and how quickly you had to react to save capital.

The Flag Pole

While the pattern itself is not completed, it is detectable as the flagpole is forming. Of course we need to wait for the flag itself to be formed to confirm the pattern and there are some important notes regarding the construction of both the pole and the flag.

The first rule regarding the construction of the pole is that these generally occur over a short period of time from one day out to about 4 or 5 days at the outside. I had noticed in Leon Wilson's latest book "The Next Step to Share Trading Success" he mentions that he feels this is not set in stone and that he has seen flag poles that have taken up to ten days to form. He acknowledges that this is generally not the case however and most traders agree with our observation that they generally take one to five days to form. Daryl Guppy in his book Snapshot Trading writes in regards to the flagpole "it is created by one to five days of extreme and continuous price action".

The flagpole may have gaps in it however it will generally not have any serious retracements. If there are any down days at all they will generally be very small in range and have little or no effect on the direction. The following diagrams illustrate our point for those who like to visualise what we are talking about. Notice in the first chart there are gaps in the flag pole however price continues in one direction. In the second chart we have shown a very poorly constructed flag pattern (for many reasons which we will cover).

Lihir Gold

The chart on the left shows a well constructed flag pole. The price moves upwards for four days in a row on heavy volume without retracing at all. There are gaps showing the excitement of the crowd and while the daily trading range is not huge on its own (i.e. bars not overly long) the rate of change over these four days is significant. Note: the long line to the left of the flag is a line I have drawn measuring the height.

Lion Selection Group

This second chart shows a poorly developed flagpole. It did have a huge day and then a second up day as it broke away from its base. It then had a down (red) day (on reasonable range and volume) that closed lower and seemed to slow momentum. The price did gap up again after this day continuing the momentum and this move defined the top of the flag pole. Price then retraced in a flag like manner although there are issues with the development of the flag as well, these are covered later. NOTE: This is an example of poor flag pole construction.

Real-time flag pole

The diagram to the left shows one of the flag patterns we monitored in real time in our newsletter.

We believe this is a text book example of a flag pattern. The price moves up strongly for four days (the doji shape on day 3 is of small concern as day 4 gaps up on the open and closes at its high).

There is no retracement in the flag pole itself - in fact there are no red days at all and the range had increased considerably. The flag was also well defined and we'll cover this in Part 2 of this article.

Before we move on from flag poles we feel we should again mention that flag poles are impossible to pick in real time. It is not until the flag itself begins to develop that we will know it is a flag pattern. I tend to be very strict regarding the rules of flag pole construction. These rules have been suggested by other traders as they have found that by sticking to the rules we have a better chance of probability.

In Part 2 of this article we will cover the construction of the Flag itself and how to set targets based on these.

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First Published: 10 May 2005 - Copyright © Jason Mitchell

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