In the realm of technical analysis, a "flag" is a chart pattern that illustrates a temporary pause or compression in directional price action. A flag is classified as being a "continuation" pattern, suggesting that price is likely to resume movement in concert with a previously defined trend.
Flags are widely accepted by long-term, swing and intraday traders as signals of potential breakouts. In addition, they provide technical traders a means by which to enter and capitalise upon a trending market.
For a flag to exist, the following market characteristics and elements of price action must be present and readily quantifiable:
- Trend: The presence of a substantial market move, whether it be bullish or bearish, is a prerequisite for the formation of the flag pattern.
- Volume: Heavy volume gives validity to the flag formation. It is important to remember that a flag signifies a momentary consolidation of price action, potentially followed by resumption of the original trend. High volume is seen as a barometer of the trend's relative strength and a predictor of its capability of extending directionally.
- Duration: Various time frames and chart denominations create flag patterns of different durations. In the intraday trading atmosphere, flags can appear on tick and minute charts. For longer term or swing trading, flags appear on daily and weekly charts.
In general, chart patterns are visual tools that aid traders in quantifying the size and scope of price action and market moves. Being able to actively identify periods of market trend and consolidation is a key function of chart-based technical trading. Chart patterns, such as flags, place market behaviour in context and provide a timing mechanism useful in either entering or exiting a given market.
There are four visual components of a flag:
- Flagpole: The "flagpole" represents the total change in price sustained during the identified trend. It is the measurement from the beginning of the move to its high or low point preceding a pause in price movement.
- Rectangle: The flag pattern itself is a rectangular channel that runs opposite of the flagpole. It is constructed by drawing lines connecting the high points of the compressed trading range in addition to the low points. The result is scaled trend lines that are parallel and give the appearance of a rectangle.
- Slope: The slope is the degree by which the rectangle runs against the flagpole. In an uptrend, the rectangle slopes downward. This formation is known as a bullish flag. Conversely, in a downtrend, the rectangle slopes upward and forms a bearish flag.
- Retracement: The retracement of a flag refers to the distance from the top or bottom of the flagpole to the top or bottom of the rectangle. Fibonacci retracements are commonly used to measure how far price has moved against the initial trend. Retracement values of 38%, 50%, 62% and 78% are key areas that can be used to project future pricing movements using the completed flag as a reference point.
Flags are some of the most widely recognised chart patterns among active traders. They're relatively easy to spot and useful in the consistent identification of trade entry and exit points.
However, it is important to remember that market follow through and trend strength are often difficult things to measure. Choppy, consolidating market phases often resemble a developing flag pattern and can provide a misleading picture of true market conditions. It's up to the trader to exercise judgment and solid rationale when employing a trading approach based upon flags.
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