Flag patterns in technical analysis are indicators of short-term price movements that occur within a parallelogram, counter to the previous long-term trend. Traditional analysts see flags as potential indicators of trend continuation. There are two types of flag patterns: bull flags and bear flags. Although they have different outcomes, both types of flags exhibit five key characteristics. These include a strong preceding trend (known as the flagpole), a consolidation channel (the flag itself), a trading volume pattern, a breakout, and a confirmation of the price moving in the direction of its previous trend.
Let’s delve into the specifics of each flag pattern and how to trade them.
A bull flag pattern occurs when the price consolidates lower within a downward-sloping channel after a strong uptrend. This channel consists of two parallel, rising trendlines. It’s worth noting that the pattern may take the form of a wedge or a pennant if the trendlines converge. During consolidation, the trading volume typically decreases, indicating that traders associated with the preceding trend have less urgency to buy or sell.
As the price breaks above the upper trendline of the bull flag, trading volumes increase, and the urgency for new and old investors to jump in returns. Analysts consider strong volumes as a sign of a successful breakout from a bull flag. Conversely, if the price breaks above the upper trendline with lackluster volumes, there is a higher possibility of a fakeout. This means that the price may drop below the upper trendline, invalidating the bullish continuation setup.
To trade a bull flag setup, traders can enter a long position at the bottom of the flag, anticipating that the price will break out towards the upper trendline. More risk-averse traders may wait for a breakout confirmation before opening a long position. The upside target for a bull flag breakout is typically as much as the size of the flagpole when measured from the bottom of the flag.
The chart below illustrates a successful bull flag breakout setup in Bitcoin’s price between December 2020 and February 2021.
Traders should exercise caution by placing a stop loss just below their entry levels to manage risks and reduce losses if the bull flag gets invalidated.
Now, let’s explore the bear flag pattern, which is the opposite of a bull flag pattern. It involves an initial downside move followed by an upward consolidation inside a parallel channel. The downside move is referred to as the flagpole, while the upward consolidation channel is known as the bear flag. During the formation of a bear flag, trading volumes tend to decline.
To trade a bear flag pattern, consider the following illustration on crypto charts.
In the Bitcoin chart above, the price forms a flagpole followed by an upward retracement within a rising parallel channel. Eventually, the price breaks out of the channel range to the downside, dropping by the height of the flagpole. Traders can choose to open a short position on a pullback from the flag’s upper trendline or wait until the price breaks below the lower trendline with rising volumes. In both cases, the short target is usually determined by subtracting the flag’s peak from the flagpole’s size.
If the price breaks below the flag’s lower trendline with lackluster volumes, it suggests a fakeout, indicating that the price may reclaim the lower trendline as support for a potential rebound within the parallel channel. To limit losses in a fakeout scenario, it’s crucial to place a stop loss just above the entry levels.
It’s important to note that this article does not provide investment advice or recommendations. Every investment and trading decision carries risks, and readers should conduct their own research before making any decisions.