Bull Flags and Bear Flags

Bull and Bear Flags are one of the simplest and potentially profitable patterns in chart analysis. Generally, this is because one can achieve a “Dual Edge” in trading the pattern, meaning the pattern tends to ‘work’ more times than not, and when the target is achieved, it yields more profit (up to two or three times as much) as the stop-loss that is incurred when the pattern ‘fails.’
Let’s look at the idealized representation of this pattern:

One cannot predict the initial impulse - known as the “flag pole” - that creates the patern, nor can one accurately predict the retracement that constitutes the “Flag” portion. The pattern derives its edge and opportunity from a price break-out above the upper trendline that forms the “Flag” portion of the move. We expect a “Measured Move” to occur which gives us a potential price projection, and location to place our stop (beneath the lower trendline of the flag) if we are incorrect.

Here are two examples of the pattern in action:



The first chart is Corn Futures on the Weekly Chart while the second example is the DIA (Dow Jones ETF) on a 5-minute chart - both selected to demonstrate the applicability of this pattern on all timeframes.

The following summary is specific trading instructions for the pattern:

Why do I like this pattern?

It is relatively simple to identify, only uses price (no complex indicators), and the stop-loss along with profit target projections are clear.

What does it look like?

Graphically, the pattern is comprised of a large volatility upward impulse move (which resembles a ‘flag pole’) which is then followed by a retracement that occurs downward in a near 45 degree angle. After this retracement is complete, a ‘measured move’ component breaks back to the upside which is roughly equal to the original flag pole portion.

The first component is the ‘pole,’ which you often can’t detect as it forms. It is the second component that creates the ‘trade.’

Once you see a clean retracement against a large, near vertical price move, this is your clue to begin looking for this trade. If the retracement is bound by near parallel channels which form a 45 degree angle, then this increases your confidence that a flag pattern is occurring.

If the retracement pulls back to the 20 period (or some other) moving average, or some other area of perceived support, this adds confidence to this pattern.

Entry

Generally, once you see price retrace about 50% of the initial ‘pole’ or price comes into a support zone, this would be your entry. If you are an aggressive trader, you can enter as price continues downward in the retracement in anticipation of a reversal. Generally, you’ll fall victim to less slippage and will get a better position if the measured move occurs.

If you are more conservative, you can actually wait for the price to break out of the upper channel and enter at that point. You’ll sacrifice initial trade location, but will put the odds a little more in your favor.

Stop and Target

Where do you place your stop and where do I play for a target? It depends on your style of trading.

The stop should go a ‘comfortable’ distance beneath the lower trend channel of the flag portion. Again, if you are conservative, you can place it just beneath the support zone or bottom trend channel.

If you’re more aggressive, you can place the stop lower than this zone, or even beneath the initial pole (of the impulse).

Keep in mind that you have a clear target once you establish your trade, and so you can easily cut that target in half to establish a clean 2 to 1 reward to risk ratio.

The target is an equal distance of the pole which is added to the bottom of the lower trend channel in the flag.

Example: If the ‘pole’ impulse is $5.00 (taking price from $40 to $45), and the retracement takes price down $2.50 to $42.50, then the ‘measured move’ target would be $42.50 + $5.00 or $47.50. Your stop could be placed where you are comfortable beneath $42.00.

Where does it occur?

This pattern occurs on any of the intraday time frames and the daily timeframe of ETFs, indexes, and futures contracts. Unfortunately, this pattern occurs less frequently on the weekly charts (though the targets are larger) and especially the monthly charts. Classic technical analysis books say that a ‘flag’ portion of the daily chart must unfold in 4 weeks time.

For a detailed explanation on how to use TradeStation specifically to project the target for a flag, visit the post “How to Project a Measured Move of a Bull Flag.“

Source : here