January 31st 2008
Everything’s a Flag
This part four of my five part series on the patterns I trade.
The Flag Pattern is a common pattern in all trending markets. The frequency of this pattern combined with its ease of identification could lead one to believe that it’s predictive qualities have been rendered useless.
I have made a career on trading this pattern. Until someone offers data to the contrary, I will continue to trade it.
Like the rest of the patterns in this series there are characteristics that distinguish good flag pattern setups. There are Two distinguishing characteristics that I look for in Flags.
1. Declining Volume. Like other consolidation patterns. A downtrend in volume inside the flag pattern is good characteristic. This seems to be one of those rules we all hear and nod our heads thoughtfully…”oh yes, declining volume, quite right”. But why is it important? The easiest way to wrap your mind around this one is to think in terms of supply and demand. When demand is high and supply is low, price moves up. When demand is low and supply is high, price moves down.
What about when:
I. Demand is low and supply is low?
or
II. Demand is high and supply is high?
In both cases price stays flat. The difference is that we do not want high demand (buyers) and high supply (sellers). This is what you get when you see small price movement and lots of volume. It’s called churn. I don’t want to see churn, because it says to me that buyers don’t have the strength to move the stock further. I begin to ask the question: when buying is exhausted, will the pattern fail? Or if price does breakout will there be enough buying pressure to continue the advance?
After an advance, lower volume in a consolidation pattern says to me there is lower demand (buying) and lower supply (selling). It’s even better when the price drifts counter to the trend like it does in a flag pattern. The reason is that despite the lack of buying by the bulls, there are few sellers. Even when the stock drifts counter to the trend, no one is exiting.
So what other characteristics separate the best flags from the rest?
2. Do the time frames Synch? You’ve heard me say it before: merge timeframes to make money. Good setups are all about putting the odds in your favor. One way I accomplish this is by finding another setup on a larger time frame and drilling down to the smaller time frame for the entry. This is going to limit the number of setups, but that’s a good thing. Flags happen all the time. You need a filter to separate the best.
Bear Trap in the daily.
Flags intraday.
One additional strategy I would employ. Bull and Bear Traps are good daily setups to trade intraday consolidation patterns. On an intraday time frame, the stock will gap in the opposite direction of the trend. Form a base, triangle, or flag and then continues on its merry way. I have often used traps to identify what gaps to play and used the intraday flag as an entry.
Then I expect this stock to skyrocket.
