How To Trade Flag Patterns
A bullish flag pattern indicates that an uptrend is likely to continue, while a bearish flag pattern suggests that a downtrend will continue.
But why do us traders refer to this consolidation as a flag pattern? This is because the price action resembles a flag on a technical analysis chart.
Let’s look into the structure of flags to ensure we are all on the same page.
Structure of flag patterns
Before bothering you with any theory, let me turn your attention to a bullish and a bearish example of the flag pattern.
As shown in the diagrams, a complete flag pattern requires the following:
1. Initial trend (pole of the pattern)
Firstly, the market must make an initial trend move. If the market trends upwards, then a bullish flag could form. If the market trends downwards, then a bearish flag could form.
On a chart, this initial move looks like a pole.
2. Consolidation (flag of the pattern)
Next, you must wait for price to consolidate in a band. This could be sideways in a range or sloping within a channel.
If the consolidation is in a channel, it must move in the opposite direction to the trend.
- In a bullish trend, price should move down.
- In a bearish trend, the market should move up.
Keep in mind that the amount of time spent consolidating will differ. However, longer consolidation periods usually equal more substantial moves.
On a chart, the consolidation (retracement) looks like a flag.
For a flag pattern to be confirmed, the market must breakout from the consolidation and resume the initial trend. Obviously, there is no way to ensure that a breakout will succeed, although the probabilities do favor trend continuation.
Hopefully, you now understand why this pattern is called what it is. The initial trend move forms the flagpole, the consolidation is called the flag, and the breakout should lead to continuation.
Although the diagrams are nice and all (if I do say so myself), what does a flag pattern look like on an actual price chart?
Flag pattern on a chart
How to trade the flag pattern
The best way to trade flag patterns is to apply a breakout approach. Here is how:
- When trading a bullish flag, market probabilities favor the continuation of the initial uptrend. Therefore, once price breaks above the upper consolidation line (resistance), you should place a buy position.
- To confirm the validity of the breakout, wait for a candlestick close above to enter.
Buy trade entry
- You have 2 options to set your stop loss. You can either place it below the resistance level with some wiggle room for the market to retrace slightly or place it below the support level of the consolidation. The first option gives a better risk to reward ratio, while the second is more conservative and prevents being stopped out of winning trades.
- A common occurrence with flag patterns is the move after breaking out of the consolidation is usually a similar size to the initial trend move. Thus is it a good idea to set your TP a similar amount of pips away from the breakout level.
Side note – To determine the amount covered by the initial move, take the distance from one swing point to the next. Then use your trading platform to calculate the pips. Great trading platforms such as MetaTrader, TradingView, Plus500 include this feature, and many others, making your job Forex trader easier.
Buy trade exit
I don’t want to waste your time repeating all the principles described above, so keep in mind that all of the reasons behind specific actions will remain the same when selling.
- When price closes below the lower line (support) of the consolidation, place a sell trade.
- Only enter if a candlestick closes below.
Sell trade entry
- Set your SL above the support level (with some wiggle room) or above the consolidation’s overall resistance level.
- Use the size of the initial trend move and set your TP a similar amount away.
Sell trade exit
Advantages of trading flag patterns
- It offers a great risk to reward ratio.
- Your technical analysis remains simple.
- It is easy to know when to enter (signals are clear).
- Stop loss levels are easily defined.
- Take profit levels are calculated objectively and with high accuracy.
- Positions are aligned with the trend.
- You are not chasing after the trend, instead you can wait patiently for the consolidation.
- Ideally, traders look for the initial trend move to occur on good volume. Followed by consolidation on low volume, then a breakout on higher volume. The decrease and then increase in volume reduces the chance of a false breakout.
- As briefly mentioned, longer periods of consolidation usually lead to greater follow through.
- You should never trade this pattern if the consolidation breaks the previous higher low (uptrend) or lower high (downtrend).
If you are looking for a simple trading pattern to participate in the Forex market, then flag patterns are a great technique to get started.
Like all approaches, it will take time, practice, and adjustment to find the positive expectancy you are after. But with persistence, you can get there.
Fly your flag