How to Trade The Flag Chart Pattern
A simple low risk chart pattern with high reward potential
Flags are excellent chart pattern trading candidates; they're generally small, which means relatively small risk and quick profits. A flag chart pattern is formed when the market consolidates in a narrow range after a sharp move. Flags can be seen in any time frame but normally consist of about 5 to 15 price bars (although that is not a rule).
The pattern has a “flag” appearance because the small rectangle (the consolidation) is connected to the pole (the large and swift move).
Flag Chart Pattern Specifications
The flag portion of the pattern must run between parallel lines and can either be slanted up, down or sideways. Flags which are angled in the same direction as the preceding move (example: pole up and flag slanting up), degrades the performance of the pattern. Therefore, you ideally want to see a sharp move higher followed by a sideways flag or a flag that is slightly angled down. If the sharp move is down, you ideally want to trade a flag that is sideways or angled higher (moving opposite the strong down move).
The move which precedes the flag portion of the pattern (the pole) must be a sharp move, nearly vertical, and be noticeably larger and swifter than the recent price moves before it. This swift and abrupt price movement shows strong buying/selling action which we hope to capitalize on by trading a breakout from the flag formation.
Trading the Flag Chart Pattern
Enter a trade when the prices break above or below the upper or lower trendline of the flag.
A stop-loss is set just outside the flag on the opposite side of the breakout. For the stock market, "just outside" is $0.01 or $0.02, in the forex market, one or two pips, in the futures market, one tick. Note that if the parallel lines of the flag are sloping then the breakout point (entry) will change over time (because the lines slope over time).
Flags are often considered continuation patterns, meaning that the breakout tends to theoretically occur in the direction of the preceding move (same direction as the pole). Examine enough price charts and you'll recognize this bias is wrong as often as it is correct. The simplest way to trade the pattern is to wait for the breakout, and trade it; anticipating the breakout direction is a more advanced skill. If a trade does break out in the same direction as the preceding move, the following profit target(s) can be used.
Profit targets are based on two different methods; one is conservative which will likely result in a quick profit, and the other is a more aggressive target which will take longer for the market to hit but results in a larger profit.
The first target is based on the distance between the parallel lines which form the flag. If the flag is 30 pips wide (in the forex market), then the profit target is the breakout price +/- 30 pips depending on if the breakout was to the upside or downside respectively. Because the market is tightly wound after a strong move, these profit targets are often hit quickly and exceeded.
The next profit target is based on the pole. Measure the distance of the pole, from the start of the pole (start of the sharp move) to the tip of the flag. If it is $1 long (in the stock market) and the breakout was to the upside, add $1 to the bottom of the flag. If the breakout was to the downside, subtract $1 from the top of the flag. The result is the profit target.
The attached chart shows the general formation, as well as where to place entries, stop and targets.
Flag Chart Patterns - Final Word and Cautions
Flags are created by a sharp price move, followed by a consolidation which runs between parallel lines (or close to it). Look to trade breakouts of the consolidation. A breakout can be in the opposite direction of the sharp move, or in the same direction. Set a stop loss just outside the flag on the opposite side of the breakout. Use one of two targets, or both: one based on the height of the flag and one based on the height of the pole. If forex trading, only trades these patterns during the volatile times of day, such as Best Time to Day Trade the EUR/USD.
If you day trade stocks or stock futures, then stick to trading during the most active times for the stock market.
The main problem with trading flags is false breakouts (trading false breakout is a strategy itself). This is when an entry is signaled based on a supposed breakout, but the price quickly moves in the opposite direction, resulting in a loss. When this occurs, consider cutting losses quickly, and not waiting for the stop loss to get hit. This keeps the loss small and gives you time to prepare for trading another breakout.
If need be, you can always get back into the trade.