*How I trade using flag patterns and why they aren’t as perfect as people say!*
In this blog post I am going to revisit a blog post from last year that proved massively popular with my blog readers and followers. It is about a very simple and basic trading pattern that I see talked about a lot in the retail trading community. The flag pattern, which can be applied to both bullish and bearish moves in the market, is a continuation pattern much like a wedge pattern or trendline bounce.
The basic principle behind flag patterns is that the market makes a momentum or trend move in one single direction (up or down) and it then consolidates. This consolidation is where the flag forms before the market then continues on another phase of its momentum move. If you have read about the Elliot wave theory then you will also know about how the markets have been proven to spend the majority of its time moving in waves with identifiable patterns. The flag continuation pattern is just another example of this.
Below is a simple line chart example of a bullish flag continuation pattern.
The movement of price is shown by the black line with the blue lines highlighting the flag like shape of the pattern. The bullish momentum move 1 is your flag pole with the consolidation waves becoming your flag. The basic way to trade this sort of pattern is to enter a long position at some point during the consolidation to be on side with the overall momentum that should still be bullish and therefore the probability of it continuing after this pause.
How do I trade flag patterns?
There are a number of ways that people identify and trade flag continuation patterns and in my opinion, some entry methods are definitely better than others. This is how I enter a flag continuation pattern.
Firstly, I like to use extra confluences other than just the chart price action candlesticks because I believe they give me a greater edge and a greater probability of the trade being a success. In addition to the trendline drawing tool used for marking on potential flag patterns, I also use:
- The 50 exponential moving average (EMA)
- The fibonacci retracement tool
- Elliot wave principles (5 wave pattern)
Let’s go back to the simple line chart with a bit more detail added. I will use it to show you the multiple layers to my flag pattern analysis.
Looking for trades.
The trade set up all starts with the price movement. I need a clear bullish momentum move before I even begin to look for consolidation to appear. If there is not a strong bullish move before consolidation then there is a very high chance that the markets will just begin to move sideways in a choppy and unpredictable way. This is no good for trading in my opinion as there is no edge.
The simplest way to determine whether the market is forming a flag pattern is to just use your brain. Get rid of everything from the chart except the price candlesticks and ask yourself “Is that a flag?”. Is there a visible flag pole (momentum) and therefore a high chance of it continuing after this pause.
“Just use your brain” – Charlie B, 2020
Once you have the foundations of a strong momentum move and price beginning to consolidate, you can then add the extra confluences. I like to add the trendlines first if possible to get a rough idea of where the 3rd touch of the flag might appear. The main benefit of this is to give you the ability to be able to walk away from the charts and just check them a few times a day to see if price is in your target entry zone yet.
I then add the fibonacci retracement tool to the previous swing high and swing low points and the 50 ema should be on the chart also. Then it is simply a case of patience and waiting for the right set up to occur. I prefer to wait for 3 clear touches of the upper or lower trendline before entering a position because this implies that the consolidation, or counter trend, has consisted of 5 waves and this forms part of the basic elliot wave theory.
Once price is in the zone of the trendline, fibonacci retracement level and the 50 ema it is time to look for some rejection candlesticks to form. If I am trading a potential bullish flag pattern then I will look for some bullish wick rejection candles to a nice bullish engulfing candle to close before entering a long position. The opposite can be applied for a bearish flag pattern.
Risk management and profit taking:
As I have said many times in my blog, the key to success is maintain a good reward:risk ratio. This will carry you through losing streaks and will always outweigh accuracy. If you are unsure about risk management then I highly recommend you read my previous blog post on the subject. You can find it by clicking on the link below.
There is no magic number for the size of the stop loss you must use because it varies depending on each trade and the price action that’s present. My general rule of thumb is to keep my stop loss placed at least 10 pips above the previous candle highs. This usually leaves me with a total stop loss of around 25 – 35 pips unless I am trading something like the GBPNZD fx currency pair that is known to be quite “pip heavy”.
One of the benefits of using the fibonacci retracement tool for trading is it can be used to provide profit targets also. I often talk about the fibonacci -0.217 or -0.618 extension levels in this blog and these are fantastic for looking for price levels to take profits when trading trends. Below is a picture of the fibonacci retracement tool with the main retracement levels and extension levels shown.
When trading trends it is an important tool to be used when trying to predict the start and completion of the next “waves”. If you combine it with a trendline you can get some very surprisingly accurate entries. When trading flag patterns I always set my profit targets at the fibonacci -0.618 extension level which is the further of the 2 extensions and I do this for one very important reason… momentum. As I said previously, the key to successful flag pattern trading is momentum and without it, the trade won’t really do anything. Remember, the flag pattern is a continuation pattern and therefore we want the momentum to continue and take us to the further fibonacci extension levels.
My basic rule when trading fibonacci retracements is the further price pulls back, the less momentum there is and therefore you should reduce your target profit level as appropriate. This works for the majority of the time for me. Flag continuation patterns only pullback slightly to the 0.382 level and therefore I target the target profit levels. Below is a table with the fibonacci retracement levels and my ideal profit target levels.
Before I show you some examples of flag pattern trades, it is important to note that they can, and do, appear on multiple timeframes. You will see and be able trade flag patterns on the daily timeframe just the same as you can on the 1hr or 4hr timeframe charts. The rules stay the same and I look for the exact same confluences. This is why I use the 50 ema and fibonacci retracement tools because they can be adjusted to any timeframe. The theory of the markets moving in waves and phases is applicable to all timeframes and waves on the lower timeframes form parts of the waves on larger timeframes.
However, what you will notice is the frequencies and accuracy of certain patterns vary massively across the different timeframes and that is why it is important to practice and backtest for yourselves.
Lets look at an example of one of my typical flag continuation trades.
This is probably the most picture perfect example for my flag continuation pattern trading strategy that I could find. I have annotated the chart above with all of the key confluences but as you can see there is a clear bullish momentum move before the consolidation. The consolidation is tight and there are 3 touches of the lower flag trendline. Price rejects the 50 ema and 0.382 fibonacci retracement level with a lovely bullish wick rejection candle.
A long positon is entered on the close of the wick rejection candle with a 35 pip stop loss to keep it below the lower flag trendline, fib level and 50 ema for protection. Target profit is set at the higher -0.618 fibonacci extension level.
Below is the chart after the trade has completed.
Alternative Flag Patterns:
There are 2 main confluences that I will always use when trading flag continuation trades. These are the fibonacci 0.382 retracement level and the 50 ema and they don’t have to be touched to the single pip but used as a support or resistance buffer. That being said, you will often see these 2 indicators become apparent in a lot of flag patterns and that is why I use them. I also always need to see a strong momentum move before the consolidation because this is imperative to the success and overall performance of the trade. Without momentum in the market, the trade will go no where.
What I don’t always need to take flag pattern trades is 3 clear touches of the upper flag trendline. This is because you won’t always see 3 form. You might see 2 touches of a flag trendline and then price snaps right away or you might see 2 touches and a double top rejection before price begins its next momentum move. So long as price is rejecting the fib 0.382 retracement level and the 50 ema is there as support/resistance then the trade is acceptable for me to enter.
Below is an example of a flag continuation trade on the 4hr timeframe chart. You will notice the trendline is only drawn off of 2 highs before I entered a short position. This is okay. The prior bearish momentum move is very clear and the consolidation forming is also very apparent and my short entry is based on the clear rejections of the 4hr 50 ema and the 0.382 fibonacci retracement level.
As you can see from the charts above, a short position entry after the multiple wick rejections of the 0.382 and 50 ema level would have been fine and a 3rd touch of the upper flag trendline never occurred. To combat any issues with a 3rd touch happening I place my stop loss comfortably above the last highs to allow for a 3rd touch and a 5th wave of consolidation to occur whilst being able to stay in the trade.
This trade produce a very quick return of 6R with a stop loss of 35 pips and a target profit at the -0.618 fibonacci extension level.
Alternative example 2: Lower timeframes
This next trade example is on the lower timeframe 15 minute chart. This is to show you that the patterns do appear on all timeframes and they should be treated exactly the same. I applied the fibonacci retracement tool to the last swing high and swing low, I have the consolidation marked on the chart and the 50 ema is in this region for extra resistance.
Like the previous example on the EURUSD FX currency pair, price didn’t quite make 3 touches of the top flag trendline but that is not a problem. I entered short on the bearish engulfing candle that closed below both the 0.382 fibonacci retracement level and the 50 ema.
This trade produced a nice 3.8R return and because it was based on the 15 minute timeframe, it took a lot less time to reach the target at the -0.618 fibonacci extension level.
When flag patterns fail!
Just like all other parts fo trading (and life), flag continuation patterns are not guaranteed to work every time. They do fail and that is why I use a stop loss order and risk management to account for this.
You will often see flag patterns that either continue to pullback after the initial consolidation and go on to the 0.618 or 0.786 fibonacci retracement levels. You might also find some flag pattern trades that do break out but the reverse. Unfortunately this is a part of trading and you need to learn to adapt and overcome these issues to remain profitable in the long term.
One of the biggest mistakes I see is people waiting and entering flag trades on the break of the lower trendline (bearish flag) or the upper flag trendline for bullish flag patterns. There are 2 reasons why this has never made any sense to me.
- By waiting for the flag pattern to be broken and entering on the candle closure outside of the flag you are sat waiting to buy at a higher price or sell at a lower price. This is completely against the fundamental basics of trading.
- This massively reduces your reward:risk ratio for the trade. By buying on the bullish break of the flag you are increasing the size of the stop loss required and decreasing the amount of potential profit in the trade.
I will show you an example of a flag pattern trade with 2 different entries and you can see the difference in reward:risk ratio.
Entry 1: CB Flag Pattern Entry
trade examples – 3 pics
As you can see, by waiting for a bearish candle to close outside of the flag pattern you dramatically reduce your reward:risk ratio in exchange for potentially increasing the probability of success. From my experience, this trade off is not welcome and by just looking at the second entry you can see that half of the momentum move was already missed at the point the trade was entered.
By increasing the size of the stop loss and decreasing the potential profit, even though the same profit target was used for both entries, the reward:risk ratio of the move was reduced by 70%!
So there we have it, that is how I personally trade flag continuation patterns and why I think some people fail at trading flag positions. The rules for both long positions (bullish flags) are exactly the same as short positions (bearish flags) you are just trading in the opposite direction.
The main points I want you to take away from this is that you need to be on side with momentum. If there is not a clear momentum move before the current consolidation or if you are unsure about it then don’t take the trade! Simple. There will always be another chance to trade a better flag set up in the future.
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