Rounded Tops and Flag Failures
What happens when a flag pattern doesn’t do what it’s supposed to do? There are two things that can happen:
- The flag forms, breaks out, triggers your trade, and then immediately comes back and stops you out for a small loss.
- The flag forms but doesn’t break out, and your trade isn’t triggered.
Case (a) is pretty straightforward. You know that you’re not guaranteed a profit from the outset, but you can contain your risk to just a small amount.
Case (b) is interesting in that you can’t make a loss in such a scenario. Remember you’re entering a stop order to enter the trade. Therefore, if it isn’t triggered, you cannot make a loss.
Let’s take two examples of the same stock, BWLD. On October 2, the stock is forming a perfect bull flag, as shown in Figure 2.25.
So far so good. It resolves itself to the upside, and you’re in profit, having been triggered into the trade at around $38.90. On October 10, another bull flag starts to form. So if you missed the first one on October 2, you have another chance here on October 10, provided the high of the flag is exceeded, preferably with rising volume.
The top of the flag is $42.12, so if the stock reaches, say $42.25 with rising volume, then we’d like to be in the trade. However, take a look at Figure 2.27 to what happens next.
It never gets going and forms a rounded top pattern. Your order is never executed, and so you neither make nor lose money. This is one of the key benefits about flag patterns. Often when they don’t work or are not going to work, you don’t lose anything at all.
Let’s now look at an example of a bear flag that doesn’t get going. Using BWLD again, the bear flag is perfectly formed on March 14, but you should also notice that it’s a double bottom, so that would give you a warning sign. If the stock breaks the previous low in January, then that’s a stronger signal than merely breaking the low of the current flag.
In order to be triggered into the short trade, your choice is that either the stock breaks below the current flag low, say around $19.50 (as the actual flag low is $19.63), or it has to break below the January low of $18.25.
Figure 2.29 shows what happens next.
The stock gaps up, the trade isn’t triggered, and yet you don’t lose anything. That’s a great result when what you anticipated doesn’t materialize. Although this isn’t perfectly formed in this particular example, just as we can get rounded tops from bull flags, we can also get rounded bottoms from failed bear flags.
Isn’t it great that you can be wrong and still not lose anything?