Flag (Bullish) Classic Pattern
A Flag (Bullish) is considered a bullish signal, indicating that the current uptrend may continue.
A Flag (Bullish) follows a steep or nearly vertical rise in price, and consists of two parallel trendlines that form a rectangular flag shape. The Flag can be horizontal (as though the wind is blowing it), although it often has a slight downtrend.
The vertical uptrend, that precedes a Flag, may occur because of buyers' reactions to a favorable company earnings announcement, or a new product launch. The sharp price increase is sometimes referred to as the "flagpole" or "mast".
The rectangular flag shape is the product of what technical analysts refer to as consolidation. Consolidation occurs when the price seems to bounce between an upper and lower price limit. This might occur, for example, in the days following a positive product announcement, when the excitement is starting to subside, and fewer buyers are willing to pay the high price that was commanded just a few days before. But, at the same time, sellers are unwilling to sell below a lower support limit.
A bullish signal occurs when the price rebounds beyond the upper trendline of the Flag formation, and continues the original upward price movement. This is considered a pattern confirmation.
When speaking about Flags, technical analysts may use jargon and refer to the flag as "flying at half-mast". Visually, this reference is nothing like a flag at half-mast, such as on a day of national mourning. Instead, this term refers to the location of the flag - at the mid-point of what would otherwise be a continuous uptrend.
Following are important characteristics for this pattern.
Flags are very similar to Pennants. However, with a Flag, the price trendlines tend to run parallel, whereas with a Pennant, the price trendlines tend to converge.
As the Flag develops, the volume tends to decrease. Following a positive product announcement, the price may have reached an unexpected high, and fewer buyers will be willing to buy. Interest in the stock may resume, however, as prices drop, and sellers begin to lower their price. The increased activity explains why you will often notice a sharp spike in volume at the end of a Flag.
Martin Pring notes in his book, Technical Analysis Explained that "Flags can form in a period as short as 5 days or as longs as 3 to 5 weeks." John J. Murphy identifies that Flags "often last no longer than one or two weeks."
In some rare cases, the price will break against the original price movement, and create a reversal trend. The pattern reversal may be signaled during the Flag formation by a sharp increase in volume, as opposed to the more typical decrease.
The duration of the pattern depends on the extent of the price fluctuations (consolidation). The greater the fluctuations, the longer a pattern will take to develop.
It is commonly held that the length of the flagpole indicates the potential price increase. When the Flag completes, the price typically jumps to replicate the height of the original flagpole, while continuing in the direction of the inbound trend.
Volume should diminish noticeably as the pattern forms.
A strong volume spike on the day of the pattern confirmation is a strong indicator in support of the potential for this pattern. The volume spike should be significantly above the average of the volume for the duration of the pattern. In addition, the volume over the course of the pattern should be declining on average.
According to Martin Pring, a pattern that exceeds "4 weeks to develop should ... be treated with caution". After 4 weeks, interest in the stock is likely to decrease to point that it is unlikely to continue in a strong uptrend.
The lack of a volume spike on the day of the pattern confirmation is an indication that this pattern may not be reliable. In addition, if the volume has remained constant, or was increasing, over the duration of the pattern, then this pattern should be considered less reliable and may actually reverse.
Shabacker writes that, "When a mast is long ... and it's Flag relatively small, we should naturally expect the movement to be pretty well exhausted when its indicated objective is reached." He suggests that when you observe this formation, and a price continuation occurs, it is best to use the flagpole as a "yard-stick" to indicate the level at which to "take profits, step aside, and watch for further chart developments."
This pattern is effectively a pause in an uptrend. The price has gotten ahead of itself with a steep rise; therefore market activity takes a break before continuing the uptrend. This pause is reflected in the decreasing trading volume. Similarly, a spike in volume marks the resumption of the uptrend.
JL,
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Linda
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