The flag represent brief pauses in a dynamic market move. In fact, one of the requirements for the flag is that it preceded by a sharp and almost straight line move. It represent situations where a steep advance or decline has gotten ahead of itself, and where the market pauses briefly to “catch its breath” before running off again in the same direction.
Flag pattern is the most reliable of continuation patterns and only rarely produce a trend reversal. To begin with, notice the steep price advance preceding the formations on heavy volume. Notice also the dramatic drop off in activity as the consolidation patterns form and then the sudden burst of activity on the upside breakout.
Construction of Flags Pattern
The flag resembles a
parallelogram or rectangle marked by two parallel trendlines that tend to slope
against the prevailing trend. In a downtrend, the flag would have a slight
upward slope. See Figure 6.6a
Figure 6.6a: Example of a bullish flag. The flag usually occurs after a sharp
move and represents a brief pause in the trend. The flag should slope against
the trend. Volume should dry up during the formation and build again on the breakout. The flag usually occurs near the midpoint of the move.
Flags patterns are relatively short term and should be completed within
one to three weeks. Flags in downtrends tend to take even less
time to develop, and often last no longer than one or two weeks. The
breaking of the lower trendline would signal resumption of downtrends. The
breaking of those trendlines should take place on heavier volume. As usual,
upside volume is more critically important than downside volume.
Measuring Implications
Flags are said to “fly at half-mast” from a flagpole. The flagpole is the prior sharp
advance or decline. The term “half-mast” suggests that these minor
continuation patterns tend to appear at about the halfway point of the move. In general, the move after the trend has resumed will duplicate the flagpole or
the move just prior to the formation of the pattern.
To be more precise, measure the distance of the preceding move from the
original breakout point. That is to say, the point at which the original trend
signal was given, either by the penetration of a support or resistance level or
an important trendline. That vertical distance of the preceding move is then
measured from the breakout point of the flag or pennant—that is, the point at
which the upper line is broken in an uptrend or the lower line in a downtrend.
Books: Technical Analysis of the Financial Markets by John Murphy
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Price Action Patterns