THE FLAG FORMATION

The state of the overall market often expresses itself in the chart patterns of individual stocks. In a sideways market, for example, we often find numerous rectangles.

In a market that is topping, an unusually large number of stocks might form a head and shoulders pattern or a descending triangle. In a market with an upside bias, we might spot an unusual number of inverted head and shoulders or ascending triangles.

A less common pattern, which emerges during bullish periods, is called the flag. Swing traders should learn to identify the flag because it is a highly reliable pattern with very strong profit potential.

Discussions of flags go back to the classic works on technical analysis by Schabaker and Edwards and Magee. Little progress has been made since then. Most modern writers add to the discussion only by updating the stock charts used as flag examples. I want to break some new ground here by discussing not only the pattern, but also how moving averages and indicators help identify the "second breakout," which is very buyable.

A flag occurs when there is a straight up move in a stock. This movement is often nearly vertical, and at the very least is extremely steep. The move is so rapid, in fact, that on a daily chart a trendline can't be drawn. Typically, the move occurs on very strong volume and lasts a few trading days. Gaps will often be present within this part of the move. (If you missed our discussion of gaps in swing trading, please see our issue archives for May 12-26th).

This rapid upside movement is called a "flagpole." Gradually, however, buyers are no longer willing to bid the stock up. Sellers, many of whom are showing extremely nice profits in a short period of time, move in to nail them down. But rather than sell off sharply, prices decline very gradually as eager buyers who missed the initial move snap up the stock.

The flag is thought of as a consolidation pattern. A stock typically leaves a consolidation pattern in the same way it enters it. The flag is therefore expected to eventually move higher. What forms after the flagpole is the flag itself. Visualize the Stars and Stripes or your own national flag flying in a gentle breeze and you will picture the flag formation.

The flag part of this technical formation typically takes the shape of a parallelogram or a rectangle that is tilted on its side and is sloping downward. Very occasionally I have seen flags that consolidate at the top of the flagpole in a normal rectangle, and more rarely still I have seen those that slope upward. As the rectangle matures, there is typically a drop off in trading volume as the stock fades as a hot issue and other sizzling stocks with more recent news take its place in the minds of traders.

It is easy to lose track of the stock at this stage, as it is not "doing anything much." However, if the stock breaks out of the parallelogram, particularly on increased volume, then it is again likely to present a rewarding trading opportunity to the alert swing trader. If, on the other hand, the stock does not break out of the parallelogram in a roughly 15-20 trading-day time period, then it is likely the flag formation will fail.

The measuring principle for the flag is more complex than for a simpler pattern such as the rectangle or triangle. First, count the number of points from the time the flagpole begins to when it ends. As an example, let's say the stock went from $13 to $18, or five points.

Now let's say the stock pulls back to $16 during the period of the parallelogram. Add the distance of the flagpole to the pullback level and we have a target of $16 + $5, or $21. Note that this target is a minimum amount, and with the flag formation it is typically surpassed. As with any measuring principle goal, this target should be judged in the context of the overall chart and support or resistance levels.

Macromedia (MACR) is a stock I mentioned in our Mid-Week Update on May 28th and that I am recommending as a Long trade in this newsletter. The chart provides an excellent illustration of the flag and its power.

On the last trading day in April MACR came out with earnings that were well above expectations. At that point the stock broke a two-month downtrend by gapping sharply higher.

The break of the downtrend line implies this is a breakaway gap, as does the enormous volume (almost six times the normal daily amount). The three trading days in late April and early May, when the stock increased 50% from approximately $12 to $18, is the flagpole.

From then on, through a little past the first half of May, the stock drifted down. Notice the parallelogram shape and the declining volume. A buy signal was given on Monday, May 24th when MACR broke through the downtrend line of the parallelogram on strengthening volume. At my first opportunity, I brought the shares to reader's attention in our Mid-Week Update.

When the flag was first discussed by the technical analysis community, moving averages were not commonly calculated. Since then I have not seen them applied to supplement analysis of this pattern. We will do just that in today's newsletter!

In the chart above, note the 30-day moving average -- a key short- to intermediate-term definer of trend. Observe how during the parallelogram portion of the flag it continued to rise, providing support. Whereas at the top of the flagpole the shares were very extended from the moving average, by the time the parallelogram ended the stock had corrected to very close to the moving average. This chart shows that the 30-day moving average should be observed closely in conjunction with the formation of the parallelogram. If this average is violated to the downside, then it is likely the flag will fail.

Note also the behavior of the indicators as MACR broke through the top of the parallelogram. MACD, stochastics and CCI all gave buy signals, adding confirmation to the analysis that MACR was about to head higher.

With Friday's close above the key psychological barrier of $20, I think MACR will head higher. The measuring principle projects a minimum target of $21, but there is no strong resistance on the weekly chart (not shown here) until $23 or $24. I've set our stop on this trade at $18.85, which is below some good hourly support.

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