Chart Patterns - Flag
Type: Continuation Pattern
Appearance: Price action bounded by parallel trendlines. In most cases the slope of the trendlines is against the trend, although this is not a requirement.
Typical Duration: up to 4 weeks (28 days)
Description: As stated above, flag patterns are continuation, or consolidation patterns. We most often see this formation when the prevailing trend needs to "take a break" and set itself up for the next leg. We also noted that the maximum duration for this pattern is 4 weeks. Although it can be much longer, the pattern seems to fail much more often if it takes too long, as traders question the continuation of the trend. Longer patterns can be classified under different names which we will study later on. Price should touch each trendline at least twice, but can do so more times. As with pennants, flag patterns are also only valid if there is a strong trend immediately preceeding the pattern. A strong trend is best characterized by a large move (approximately 15% or more) with a relatively steep slope. If there is no such trend, then the pattern should not be traded.
Strengths: This is a very common pattern in the forex market, and has a fairly high success rate if traded correctly. Combined, these two facts make it a potential gold mine in the long run.
Weaknesses: False breakouts against the trend are common and can throw a wrench into any trading plan involving flags, no matter how well thought out it is (unless you're planning on a false breakout happening). A false breakout would be, for example, a flag forming in a strong downtrend, then price piercing the upper trendline, closing above it for a few days and then collapsing right through to hit your original target. Since most traders would place a stop loss just above the upper trendline, they would be quite frustrated to find out that they had been stopped out only to see price reach their original target a few weeks later. It should be noted that if the pattern is very clear, there may be clusters of stop loss orders all in the same place, so some of the larger market participants may consciously try to move the market to clear out those orders. This is called "stop hunting", and is common practice in the forex.
How to trade it:
Measure rule - calculate the difference in price between the beginning of the trend and the beginning of the pattern (the side of the pattern further from the start point of the trend). Price should move by approximately the same amount from the opposite trendline to the end of the trend. Set your target slighly before this point.
Breakout - once price breaks out of the formation, take the trade and ride it until either your stop loss order or your take profit order are filled, unless you see some new information enter the market which would invalidate your trade. Many traders also wait until a daily candle closes outside of the flag before considering the breach to be a true breakout.
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