Bullish flag formations are found in stocks with strong uptrends and are considered good continuation patterns. They are called bull flags because the pattern resembles a flag on a pole. The pole is the result of a vertical rise in a stock and the flag results from a period of consolidation. The flag can be a horizontal rectangle but is also often angled down away from the prevailing trend. Another variant is called a bullish pennant, in which the consolidation takes the form of a symmetrical triangle.
The shape of the flag is not as important as the underlying psychology behind the pattern. Basically, despite a strong vertical rally, the stock refuses to drop appreciably, as bulls snap up any shares they can get. The breakout from a flag often results in a powerful move higher, measuring the length of the prior flag pole. It is important to note that these patterns work the same in reverse and are known as bear flags and pennants. Bull flags typically begin to surface in conjunction with a new market rally.
Bull Flag Pattern have five main characteristics
The preceding trend
The consolidation channel
The volume pattern
A breakout
A confirmation where price moves in the same direction as the breakout
The bullish volume pattern increases in the preceding trend and declines in the consolidation. This implies that the traders pushing the prevailing trend have less urgency to continue their buying or selling during the consolidation period, thus setting up the possibility that new traders and investors will take up the trend with enthusiasm, driving prices higher at a pace quicker than usual.
Bullish Flag Pattern Example
In this example of a bullish flag pattern, the price action rises during the initial trend move and then declines through the consolidation area. The breakout may not always have a high volume surge, but analysts and traders prefer to see one because it implies that investors and other traders have entered the stock in a new wave of enthusiasm.
How to Trade a Bullish Flag Pattern
A trader can establish a strategy for trading such pattern by merely identifying three key points: entry, stop loss and profit target.
Entry: Even though flags suggest a continuation of the current trend, it is prudent to wait for the initial breakout to avoid a false signal. Traders typically expect to enter a flag on the day after the price has broken and closed above (long position) the upper parallel trend line.
Stop Loss: Traders typically expect to use the opposite side the flag pattern as a stop-loss point. For example, if the upper trend line of the pattern is at $55 per share, and the lower trend line of the pattern is at $51 per share, then some price level below $51 per share would be a logical place to set the stop-loss order for a long position.
Profit Target: Conservative traders may want to use the difference, measured in price, between the flag pattern’s parallel trend lines to set a profit target. For instance, if there is a $4.00 difference and the breakout entry point is $55, the trader would place a profit target at $59. A more optimistic approach would be to measure the distance in dollar terms between the pattern’s high and the base of the flagpole to set a profit target. For example, if the lowest price of the flagpole is $40, and the top of the flagpole is $65, and if the breakout entry point were $55, then the profit target a trader might expect to see achieved would be $80 ($55 plus $25).
While no one knows whether the market rally will continue or reverse, traders should follow price action and let the probabilities take care of the rest. While all chart patterns are susceptible to false signals and surprise moves, bullish flags are among the most reliable and effective patterns.
Sources:
-Investopedia, Flag Definition, accessed 28 December 2023, <https://www.investopedia.com/terms/f/flag.asp>
-Investopedia, Bullish Flag Formation Signaling a Move Higher, accessed 28 December 2023, <https://www.investopedia.com/stock-analysis/cotd/answ20090105.aspx>