Jason Mitchell Articles
Constructing and Trading Flag Patterns - Part 2
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Construction of the Flag

Length of Development
Just as we have some rules regarding the development of a flag pole, there are also strict rules regarding the construction of the flag itself. As part of a short term movement the flag itself is generally formed over about 4 to 5 days. It can be less although it is hard to confirm a pattern with less than three days. The flag can take a little more time to develop than the pole but generally 5-6 days is about as long as they last. We again noticed in Leon Wilson's new book "The Next Step to Share Trading Success" that he recognises that flags can take up to 10 days to form, we would tend to agree with this figure more than we did in the development of the flag pole. It should be noted however flags can form very quickly, and the breakouts happen even quicker. Daryl Guppy suggests that flags that take longer than 10 days to develop lose their "vitality" and are not as likely to hit or exceed their target.

Rules of Development
The flag itself is made up of two parallel lines. These lines must be parallel for the flag to be valid. If the lines come together this is a pennant pattern, if they move apart then it is definitely not a flag pattern.

Flag Pattern - Parallel
Flag Pattern - Parallel

 

Pennant Pattern - come together
Pennant Pattern - come together

The flag should also be on a downward sloping angle and not to the side or upwards. Surprisingly flags with upward angles actually have less likelihood of achieving their targets in fact some say it is a bearish pattern. The angle of a flag is hard to determine although Leon Wilson suggests a figure of 70% is an optimum angle and anything less than 45% is usually less reliable. We do not calculate the angle in our own trading.

One of the most important features of a flag pattern which determines its strength is the height at which the flag is on the flagpole. The flag should be at the very top of the pole and not towards the middle. The lower the flag the less probability of the pattern reaching its upside target.

Flag: Top of Pole/Half Mast

If the flag is flying half mast (therefore the flag begins halfway up the pole) then the pattern is unlikely to reach its target. We do not trade the pattern if it is not towards the very top of the flag pole.

LSG

Looking back to the earlier chart of LSG, which we felt showed a weak flag pattern (shown left) we would point out a few issues with the flag itself, (we already discussed the pole). While the parallel lines defined almost the entire flag one of the first day's highs actually went above the line. If we decide to call this the top of the pole as some trader's may then the pattern started just below the top of the pole, which is also a weaker sign. Either way the pattern is not as strongly defined as the others that have been shown.

The fact the pattern did seem to follow the psychology of the flag shows that it was a flag - just a very poorly constructed one. These generally have less probability of hitting their target and the fact that momentum did not increase immediately on the breakout confirms this pattern was not as strong as others. It did exceed its target in the end - partly due to a bullish market.

Should prices break below the bottom line of the flag pattern the whole pattern is invalidated. Price must stay between these lines for the pattern to be valid. This is with the exception of course of the upside breakout. This is a very important rule.

The 50% Line
This is a rule that some traders use and many other traders don't and we almost did not include it for this reason. We tend to use it ONLY if the flag pole is made of one large day and preferably is a dominant candle. This is similar to the 50% mark on a dominant candle. We would suggest however that we only use it in certain situations and we mention it only for completeness in the article. We do note many of Australia's authors and traders (such as Daryl Guppy, Leon Wilson and others) do not tend to speak about this rule. The 50% line is the halfway point between the top and bottom of the flag pole. If the flag goes below this point then the premise is that the chance of it hitting its target on the breakout is reduced considerably. We do not subscribe to this as a general rule and some traders believe using such a rule will take you out of many good opportunities.

The 50% mark is simply measured by halving the height of the pole. For example if the pole went from $0.22 to $0.29 then the halfway point would be $0.245. This is found by finding the height of the pole in a dollar amount.
Eg. $0.29 - $0.22 = $0.07

Half of $0.07 is $0.025. Therefore we add this amount to the bottom of the flag pattern and find the half way mark (note we could also take the amount from the top of the flag pole - we just felt it was easier for people to add).
$0.22 + $0.035 = $0.255

Setting Price Objectives
One of the best things about patterns such as the flag and the ascending triangle is the pre defined price target that the pattern gives us to sell at. This allows us to ascertain a risk reward calculation as well as have a defined management plan should the trade go right. (We cover what to do when they go wrong in a subsequent article).

Again there are some strict rules regarding the setting of targets with a flag pattern. The flag pole is what we use to measure the target and the upper trendline of the flag itself is used as a projection point. What I mean by this is the height of the flag pole is measured in terms of dollars (as we did for the 50% line). This time however we take the height of this line and add it to the value of the point where the flag pattern is penetrated. It should be noted that the target set for flag patterns is a minimum target and is often exceeded.

For example let's say we have a flag pattern again with the flag pole going from $1.20 to $1.38. The height of this flag is: $1.38 - $1.22 = $0.16

We then use this figure and add it to the value of the upper line in the flag pattern at the point of breakout. If the stock broke out of the flag pattern when the trendline was at the value of $1.32 then the minimum target is: $1.32 + $0.16 = $1.48

If the value of the line had been at $1.31 then the target would have been $1.47 ($1.31 + $0.16). This figure must be re-adjusted daily as the value of the trend line drops in the flag. This is of course until the pattern experiences a break above the line. The following diagram illustrates visually the concept of adding the projected height from the upper line of the flag itself.

Target - Height of Pole

If in the above chart the price did not break out on the day it has we would need to re-adjust the target based on the value of the upper line of the flag. If the line drops by 1c per day so does the target.

How Do We Measure the Flag Pole?
There are reasonably precise rules regarding how to measure the height of a flag pole as this is the figure used for the target at which we will sell at. Prices can fall back from their target reasonably quickly in pattern trades and so we need to be very careful to set the right target so that we know when to act. Even being out on the target by 1 cent in certain shares can mean the difference between a good result and an ordinary result. If the target is hit and price pulls back and you are not out then you may need to chase price downwards to get out.

The flag pole is deemed to have started on the first bar that experienced stronger than usual upward movement. As Daryl puts it in Snapshot Trading (p.119) "The flagpole starts with the day signalling the beginning of the fast rise".

This can be a little bit subjective however it most cases it is reasonably clear. The change in pace in a share price is often visible quite easily on a chart in hindsight and this is all we need to do with this measurement.

The fast rise can include days that gap up. In the calculation of the flag pole, if the initial day of the pole gapped up then we include the gap as part of our calculation.

The diagram above illustrates taking the gap of the move in to consideration for the height.

So the bottom most point of our flag pole is the point at which it starts to rise quickly, or to put it another way when momentum kicks in.

The top of the flag pole is calculated at the highest point prior to the retracement in to the flag pattern. The above diagram shows how the flag pattern starts just off the top of the pole however the height of the pole is measured to the point of the highest high.

    Basic Guidelines for Setting Targets on a Flag Pattern:
  • The bottom of the pole starts where price begins to accelerate or rise quickly
  • The top of the pole is the highest high before prices retrace in to the flag pattern
  • If there is a gap on the initial day of the flag pole this is included in the calculation
  • The height of the flag pole is projected from the upper line in the flag at the point of breakout
  • This target is generally a minimum - flags often exceed their targets.

These articles have been taken from a series on Trading Flag Patterns by private trader Jason Mitchell and his newsletter the StarTrader Report. In further articles Jason covers some of the more important points on trading flag patterns including how to find flag opportunities, how to enter in to a flag trade (looking at both an aggressive and conservative entry methods) and most importantly how to manage both successful and unsuccessful trades. He also shows a selection of actual examples of flag trades and patterns to help people recognise the differing ways in which these may appear on a chart in real time. During this series of articles Jason showed two real time flag trade's (i.e. chart shown before the entry) being MCR and CEY. These returned 16% and 14.57% respectively - both within 7 days.

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First Published: 10 May 2005 - Copyright © Jason Mitchell

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