The flag pattern is considered to be one of the most popular chart patterns, mainly due to its simplicity and reliability. It is called a flag pattern as it resembles a flag on a flagpole. Depending on the overall trend and shape, a flag pattern can either be bullish or bearish depending. Both are considered as continuation patterns.
In this blog post, we break down the structure of the flag pattern and learn how they can help improve your trade process.
How to the flag is formed
Both the bullish and bearish flag patterns consist of two main elements: a flag pole and a flag. The flag pole represents an initial trading impulse, while the flag reflects the consolidation of the recent gains. During the creation of the flag, the price consolidates within a channel, which resembles a flag.
The consolidation phase is always angled contrary to the trend impulse creating the pole, so it represents a healthy correction after a strong impulsive move. It is important to note that the retracement (the flag) shouldn’t go beyond 50%, or 61.8% maximum, of the flagpole.
When the price consolidates in the formation of parallel channels, it is called a flag pattern. If however, the resistance and support lines converge, the patterns are referred to as a wedge or pennant pattern.
Volume is another important aspect of this pattern. Ideally, volume levels should be confirmed the flag pattern by showing:
- an increase in volume during the initial impulsive move (the flag pole)
- the consolidation phase should witness a decreasing volume
- the final breakout move in the direction of the prevailing trend should be accompanied by surging volume
The third instance is very important as it shows that investors have initiated a new wave of buying or selling.
Trading the flag pattern
Let’s now take a closer look at how we ought to trade the flag pattern. As with every pattern, we try to identify as many key elements of the pattern as possible and confirm its validity before we engage in a trade.
Below, we see a BTC/USD hourly chart. The price initially moves higher in an impulsive fashion before creating a short-term high. The second phase of the pattern starts when a trend of higher highs breaks and the price action starts contracting.
A consolidation phase takes place as the price action trades within a descending parallel channel – the flag – for some time before the bulls manage to break the range and push the price higher.
Up to this point, we have a flag pattern in the development. The activation takes place after there is a clear and sustainable break in the direction of the prevailing trend. At this moment, we enter a buy trade, looking to capitalize on renewed buying interest.
Before we move to take profit and stop loss elements, let’s take a step back and pay more attention to volume figures. As aforementioned, the volume increases during the initial move, then decreases in the consolidation phase before erupting higher to fuel the new wave of buying. In this particular case, we have another confirmation that this bullish flag is valid and legitimate.
Once we have entered a trade, we look at the exit spots. The take profit order is calculated by measuring the distance of the initial move. That distance should then be copied, with the starting point at the beginning of the breakout move. The end of the trend line signals a level at which we consider closing the trade.
On the other hand, the stop loss should be placed within the flag, as any move that brings back the price action to a zone inside the flag, should be considered invalidation. Of course, the price can still move higher, however, this shouldn’t be seen as the bull flag pattern. So, any move to the inside of the flag, after we have registered a clean break, should be considered an invalidation of the pattern.
If you played this move according to our advice, your entry would be around $8150 and take profit at $8600, which translates into a 5.5% gain. On the other side, the stop loss should have been placed at $8050, translating into a 1.2% risk.