Introduction to the Stock Market_10. Chart patterns_ Flags and pennants trading strategy

Lesson 10: Chart patterns. Flags and pennants trading
strategy

Pennant pattern
Before entering a trade based on this formation, you of course need to have a
predetermined entry point, stop-loss and profit target. The first step is to measure the
height of the flagpole.
After the price has entered the consolidation area (which allows for the measurement
of the flagpole), we set our entry point at 10% of its height above its highest point.
This should help filter out any false breakouts from the formation.
Our stop-loss should be 25% of the flagpole’s height and is placed below the entry
point, thus 15% below the flagpole’s high. This will protect you from an eventual
failure of the pattern’s continuation nature.
As for the profit target, we will be using a scale out strategy. Our first profit target is
the amount risked, i.e. 25% of the flagpole’s height. As soon as it is reached, we take
out half of our position and we will move our stop up to the entry point. This leaves
us with a profit of 25% of the flagpole’s height on the first portion of the trade, while
the remainder may drop to breakeven in the worst case scenario.
The profit target for the remainder of our position will be equal to the length of the
flagpole, starting from its top, i.e. 90% of the flagpole’s length up from the entry point
(the 10% difference comes from the entry point being 10% of the flagpole’s height
above its high).
Example

For the screenshot above we have used an hourly chart of the GBP/USD cross. The
market broke out of an established trading range at (1) and formed a flagpole (bar 2).

Once the price action later entered a consolidation area and it started resembling a
flag/pennant formation, we begin to calculate the pattern’s elements in order to
position ourselves accordingly.

The flagpole’s high is at 1.7098 US dollars and its height is 48 pips. Thus, we enter
at 10% above its height (or 5 pips), at 1.7103, as marked by the purple horizontal
line. Our stop is placed 25% of the pole’s height below the entry (or 15% beneath its
high – 7.2 pips), at 1.7091 – visualized by the red horizontal line.

Our final profit target is 100% the flagpole’s height extended above its high (or 90%
above the entry point), thus at 1.7146 US dollars, marked by the green horizontal
line.

However, we said we will be scaling out from the trade, as soon as we profit the
amount risked. This means that when the price rises by 25% of the flagpole’s height,
projected from the entry point, we will exit half of our position and move our stop to
breakeven. The initial profit target was reached at 12 pips above the entry level, or at
1.7103 + 0.0012 = 1.7115 US dollars, visualized by the black horizontal line. It was
hit at bar 3. We then exited half of our position and moved our stop-loss to
breakeven, before our final profit target was reached shortly after.

Flag pattern

Like pennants, flags also begin with a very strong initial move, followed by a
consolidation area. The climactic bar which forms reflects the bulls’ dedication to
buy, disregarding the price they are paying – they just want to be on the market at all
costs. Such a move is often triggered by a major economic indicator, interest rate
decision etc.

After the initial spike, some bulls lock in profits, which allows bears to try and bring
the price down but in many cases they won’t possess enough selling power to
overcome the bulls, which will eventually lead to the upward breakout and trend
continuation.

Due to the two patterns’ similarities in formation and outcome, they are also traded in
an analogous manner. Again, we first need to measure the flagpole’s height. The
entry point is above the high of the flagpole, with a distance equal of 10% of its
height. The calculation and placement of the stop-loss level is also identical to the
pennant pattern’s – the stop is placed at a distance of 25% of the flagpole’s height
below the entry point (or 15% of the height below the flagpole’s highest point).

Once again, our first profit target is equal to the amount risked, projected up from the
entry point (25% of the flagpole’s height). As soon as it is reached, we exit half of our
position and move our stop-loss to the breakeven level (entry point), so that in the
worst case scenario we are left with the profit from the first part of the trade.

Once that is done, we aim for the second profit target, which again is equal to 100%
of the flagpole’s height, projected up from its highest point (90% of its high projected
up from the entry point).
On the screenshot below you can see a reversed flag formation.

Rules are important
In order to improve our chance of success with both patterns, it is crucial to follow up
on the entry and stop-loss guidelines we earlier underscored. It is of utmost
importance to respect the entry rules to filter out potentially losing trades. In the
example below you can see how a potential flag formed a flagpole but an early entry
at the high of the flagpole, disregarding our established entry rule, would have
gunned our stop.

The flagpole’s high and low were at 1.6458 and 1.6310, thus its height was
approximately 148 pips. According to our strategy, we should have entered at 10%
that amount above the high itself, but the market initially failed to rally to that point,
thus you should abstain from going long.
However, if a trader was so eager to hop on the market at the high of the flagpole
that he would disregard the entry rule, he can’t filter out potential failed flags. Say he
entered at the flagpole’s high and he placed a stop-loss equal to 25% of its height
beneath the entry point at 1.6421 USD (1.6458 USD – 0.0148 USD x 0.25).

It is visualized by the red line, and as you can see it was hit, rendering the trade a
loser.