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This chapter is from the book

Consolidating Chart Patterns

My favorite chart pattern is the flag. This occurs after a thrusting surge (the flagpole) then consolidates to form the actual flag. The thrust can occur in either an upward (bullish) or downward (bearish) direction. A flag occurs during a persistent and dominant trend and temporarily interrupts that trend before it resumes.

The flag itself consists of the price pattern rebounding off two parallel interim trendlines before breaking out in the direction of the dominant trend.

Bull Flag

With bull flags, our entry is a buy order, and our stop loss is a sell order. We anticipate a rising stock price.

Figure 2.7

Figure 2.7 Bull flag

So here we can see that we have the makings of a trading plan, and you enter your buy order at either point A or B.

Point A is at the level of the top of the flag. This is the most conservative entry point because it is where the price is making new highs. You must make sure that volume is increasing as the new high is made. Increasing volume means there is conviction behind the move, which makes it more likely to be sustainable.

Point B is where the price breaks out of the flag itself. This is more aggressive than Point A and again requires increasing trading volume to demonstrate conviction in the move.

If the entry is activated, then you need a stop loss. Point C is the level where, if you were already in the trade, you’d exit with a small loss.

This is your basic trading plan for a bull flag within the context of an upward trend.

Bear Flag

With bear flags, our entry is a sell (short) order, and our stop loss is a buy order to close the position. We anticipate a falling stock price.

Figure 2.8

Figure 2.8 Bear flag

We enter our sell (short) order at either point A or B.

Point A is at the level of the bottom of the flag. As such it is the most conservative entry point because it is where the price is making new lows. You must make sure that volume is increasing as the new low is made. Increasing volume means there is conviction behind the move, which makes it more likely to be sustainable.

Point B is where the price breaks out of the flag itself. This is more aggressive than Point A and again requires increasing trading volume to demonstrate conviction in the move.

If the entry is activated, then you need a stop loss. Point C is the level where, if you were already in the trade, you’d exit with a small loss.

This is your basic trading plan for a bear flag within the context of a downward trend. You can see examples of both a bull and bear flag in Figures 2.9 and 2.10.

Figure 2.9

Figure 2.9 Bull flag chart

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Figure 2.10

Figure 2.10 Bear flag chart

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The chart in Figure 2.9 is actually a cup and handle pattern. These manifest themselves as flags at the end of a bowl pattern or right around a double top. If they break to the upside, two areas of resistance are broken, the flag itself and the previous high.

Flags Within the Context of a Trend

Now, what if I said to you, how about finding flags within the context of a trend? That means you can play the flag, knowing that the trend is backing you up. Now we’re beginning to add some backbone to our trading plan.

All we have to do is draw a trendline to see if the flag is forming within the context of a trend.

In the previous two examples you could see that this is the case. The bull flag is within the context of a two-month uptrend, and the bear flag is within the context of a one-month downtrend.

Figure 2.11

Figure 2.11 Bull flag resolved to the upside

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Figure 2.12

Figure 2.12 Bear flag resolved to the downside

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I haven’t drawn the trendlines in at the precise angles in these charts, but if they are broken by the stock price action, then you would exit the long (bull flag) or short (bear flag) positions. Similarly, to enter into the long stock position, the price would need to rise above the top of the bull flag or break up through the upper flag trendline.

To enter the short stock position, the price would need to fall below the bottom of the bear flag or break down through the lower flag trendline.

Can you see how you can make simple rules regarding the trend and flag patterns in order to create a cohesive trading plan?

When a stock is trending, it typically does so in steps...or flags. So by identifying trending stocks, we’re going to find flags too. Not all flags are in long-established trends. For example, take a look at this fantastic bull flag in Figure 2.13 that I found as the stock was emerging from a downtrend.

Figure 2.13

Figure 2.13 Bull flag in context of downtrend

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As you can see in Figure 2.14, the stock doubled in one month after breaking out from the bull flag pattern. Furthermore, by simply drawing a trendline as the stock rises, you could manage your trade and exit with a huge profit once that trendline was broken.

Figure 2.14

Figure 2.14 Bull flag breakout from downtrend

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Managing Your Profits

Stop losses are easy to understand and in the context of flag patterns, easy to identify and enter. However, one of the major difficulties traders have is how to manage profits. There are two areas of importance:

  1. Taking partial profits or scaling out
  2. Letting the rest run

You’ve probably heard things like “cut your losses and let your profits run.” That’s all well and good, but you must have a mechanism to do it. Flag patterns give you such a mechanism.

The One to One (1:1) Theory

If you intra-day trade the indices such as the S&P e-minis, then you may be aware of a pattern occurring that is known as an “equal drive” or 1:1. Supposedly the pattern originates from Elliott Wave and Gann theory, but having studied them in depth for several years, I’d stay away from them both in order to save yourself from going round in circles and getting very frustrated!

Let me save you some time right here and now. Counter to the Gann and Elliott theory, there is no pre-ordained destiny for the markets whatsoever. There are three factors that affect a stock price:

  • Technical analysis (of which chart patterns, Gann, Elliott, Fibonacci, and a myriad of other techniques may be part)
  • Fundamental analysis (the study of corporate and economic financial information)
  • News (international, national, industrial, corporate, political, economic, and financial)

When news is at the fore, all the other techniques pretty much go out the window until the market returns to normal and stops over-reacting either out of panic or greed. This is why black-box trading systems never work brilliantly all the time. To be consistently successful, you need to factor in the human element for which the catalyst is a news event such as an earnings report, an economic data release, an election, or a surprise of any kind.

Back to 1:1s. The concept involved here is that a stock makes an “impulse” move in the direction of the dominant trend and then retraces before making another move in the direction of the trend.

The theory is that the second impulse move will keep going until it reaches the magnitude of the previous impulse move. Does this always happen? No, of course not, but we’re using the theory not to help us enter our trades, but to help us manage our profits.

Figure 2.15

Figure 2.15 1:1 bullish

Figure 2.16

Figure 2.16 1:1 bearish

It’s also feasible that the retracements themselves can make 1:1 moves, but you don’t need to look at those for the purposes of managing your profits. So the question is how does the 1:1 theory help you manage your profits? Well, if we assume that the first impulse move occurs before the flag pattern, then we can project a target for afterwards if the stock price breaks out of that flag pattern in the direction of the trend.

For example, take that chart of SWC again from Figure 2.14. We can see that the second impulse move is very similar to the first move before consolidating again into the second flag pattern.

Figure 2.17

Figure 2.17 SWC 1:1 move

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Of course, who’s to say how long this would continue? For our purposes we can use the theory to identify a target at which to take partial profits. The question is—at what point on the chart would you take partial profits? In my experience about 50% of the initial impulse move is a sound place to take some money off the table while letting the rest run with the trendline serving as a trailing stop.

Figure 2.18

Figure 2.18 Setting profit target using 1:1

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The trade is entered above the high of the first bull flag. The initial stop placement is just below the flag bottom.

As the stock price rises and we take partial profits, we can move our initial stop up to where we entered the trade and manage the remaining profits using a trendline.

Figure 2.19

Figure 2.19 Managing your profits by adjusting the initial sell stop loss

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It’s important to note that you do have discretion over the trendline and how steep you want to make it. In the case of SWC, it’s clear that the stock is making another bull flag pattern, so you may want to give it a bit more room to form the pattern and move further to the upside by adjusting the trendline and making it a bit shallower. With SWC it’s quite feasible that you could have ridden this stock all the way to $20, almost doubling your money in just over one month.

Figure 2.20

Figure 2.20 Managing your bull flag profits by using a trendline

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The same works exactly in reverse for bear flags.

Figure 2.21

Figure 2.21 1:1 with downtrends

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As with the bull flags, we don’t know how long the next impulse move will be, but our objective is not to try to predict the future. It’s to employ a method to take partial profits and let the rest run in an organized and controlled way. Please don’t fall into the trap of trying to predict the future. You’d be doomed to fail, sentencing yourself to a life’s work that sends you round and round in circles. I’ve been there, so be warned!

You’re going to look to take partial profits when the new impulse move reaches 50% of the previous one. You let the rest run with the downward trendline serving as your trailing stop.

Figure 2.22

Figure 2.22 Managing your bear flag profits

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In this example we’re assuming that we see the trade on February 13. We place a sell stop limit to open at just under $15.00 (the low of the flag). Our initial stop loss is just over $16.00 (the top of the flag area), and we set our first target for partial profits at around $13.50, which represents a downward move of around $1.50, which is around 50% of the previous impulse moves downward.

Figure 2.23

Figure 2.23 Managing your profits by adjusting the initial buy stop loss

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As the stock price falls in your favor, you can move the initial stop down to where your entry order was so that you put yourself in a no-lose position; in other words, “moving your stop to breakeven.”

Figure 2.24

Figure 2.24 Using a trendline to exit a profitable trade

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We can see here how we took partial profits at the 50% mark (around $1.50 down from our entry point, making our first target around $13.50 as our initial trade entry was just below $15.00). The remainder of our position is stopped out at a profit as the stock bounces up and hits our trendline at around $12.00.

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