The foundation of technical analysis is based on the premise that individuals can predict highly probable outcomes by analyzing various data points. Despite this, it is a startling reality that most individual traders will lose money consistently when trading in the financial markets, an achievement that a chimp throwing darts at a wheel of stocks could not match.
Regardless of this reality, the culture among the retail finance community appears to empower traders with little to no financial training or education to believe themselves to be among the chosen few who can do what they believe others can not. This post will seek to educate retail traders on how to successfully trade a bearish flag pattern as well as highlight the risk factors associated with bearish flags.
What is a Bearish Flag Pattern?
As the prices of securities fluctuate, past price data is recorded and can be observed on what we call price charts. Occasionally, the data recorded onto these price charts form patterns. A pattern, such as the bearish flag, is simply a recognizable configuration of price movement.
The bearish flag can be observed in stocks that are experiencing a downtrend. As it is a continuation pattern, it indicates that the downtrend will continue and the price of the stock is likely to fall further than it already has.
As you might have deduced from the name, the bearish flag was coined as a result of the fact that the price pattern resembles an upside-down flag flying from a pole. It is formed after a sharp drop in the price of a stock is followed by a period of consolidation. The sharp drop represents the flag pole and the price movements during the period of consolidation that follows represent the flag itself. You can see an example of the bearish flag pattern in the chart below.
How to Identify a Bearish Flag Pattern?
Of all the various price patterns that exist, the bearish flag pattern is among the easiest to identify and confirm as it only consists of five characteristics. Let’s explore these now.
To identify the bearish flag pattern, you should begin with locating the flag pole of the pattern. This will be either a sharp or steady drop in the price of the security and will act as the basis of establishing the trend.
After you have located the flag pole you should begin to identify a range of consolidation in the price of the security. This period of consolidation represents the “flag” itself. During this consolidation, you may notice that the price fluctuates up and down while trending slightly higher. The higher end of this consolidation will act as a resistance line and the lower end will act as support. You can see these two lines outlined in the chart for Advanced Micro Devices above. In order to confirm the bearish flag pattern, the price of the security will need to fall through this support level and continue the overall downtrend.
Flag patterns are typically shorter than other patterns and they usually form within three weeks. The most reliable flags appear during steep, quick price trends. The trends might be up or down, but prices rise or fall quickly, moving several points in just a few days to a few weeks.
When you are selecting a flag to trade, the most important guide will be the rapid, steep price trend. If prices are fluctuating up or down and form a flag then you would be well-advised to avoid this trade. The flag must be a place where the stock can take a break from its rapid pace. Prices move against the short-term trend for several days before continuing on.
Finally, volume is a key indicator to keep an eye on when trying to identify a bearish flag. You can expect that the volume trend is likely to recede over the course of the formation. Whilst this is not an inviolate rule, it is usually the case.
To summarize, bearish flag patterns have five main characteristics;
- A sharp drop in price;
- A consolidation period;
- Volume patterns;
- A breakout;
- A confirmation where the price moves in the same direction as the breakout.
It is essential that traders locate and identify patterns correctly. Properly identifying a pattern is the first step to successfully trading it. An incorrectly identified pattern can lead to significant losses. Ensure that every element of the pattern is present, especially the confirmation, before entering your trades.
Bull Flag vs Bear Flag
If a bearish flag pattern indicates a continuation in the current downtrend, then a bullish flag pattern indicates the opposite. Both patterns have flag poles and periods of consolidation with the period of consolidation trending in the opposite direction of the prevailing trend. This means that in a bearish flag, the consolidation trends slightly higher, and in a bullish flag, the consolidation trends slightly lower.
The strategies for trading these two patterns are very similar although traders should be more cautious of trading bull flags as they are statistically less reliable than their bearish counterparts. This means that traders should set stricter stop-losses and employ the use of more stringent risk management tactics when trading bullish flags.
Can a Bear Flag Break Up?
The simple answer to this question is yes. No pattern, however reliable, is immune to failure. While bear flags can be highly reliable technical patterns, in a financial world that is abundant with price trend reversals, no continuation pattern is completely guaranteed.
How to Trade a Bearish Flag Pattern:
When the bearish flag is formed its price action fluctuates upwards and creates both support and resistance lines. The bearish flag is confirmed once the price falls through the flag’s support line. As such, the best way to trade the bearish flag is to wait for the price to fall through its support and then enter a short position. Many inexperienced traders will be eager to enter their positions early but would be well advised to mitigate their risk by waiting for confirmation prior to entering any positions.
Proper risk management is the key to the longevity of every successful trader. As such, entering a position is only half of the equation for a successful trade. The other half will be in determining your exit strategy.
Setting Your Stop Loss Order
As a general rule, you should set your stop-loss order at the top of the flag’s resistance level. In order to calculate your take-profit point, you will need to measure the distance from the flag pole. The trend line should be copied, starting from the point where the breakout occurred, with the ending point signaling a level where you should consider setting your take-profit order. Let’s take a look at our previous example to see how this strategy would be implemented in the real world.
As you can see above, AMD experienced a sharp drop in the price of its stock. This price drop represents our flag pole. Once the drop concluded, the value of the stock began to consolidate and started trending slightly higher. These price fluctuations provided us with our much-needed support and resistance lines.
We used the top of that resistance line to set our stop-loss orders (SL) and essentially wait for the price of the stock to fall below our support line. Once it fell through, the bearish flag had been confirmed and this point acted as our entry point (EP). After we have entered our short position, we can draw a line down from our entry point to determine our take profit point (TP).
It should be stressed that trading in hindsight is an extremely straightforward endeavor, any fool with an internet connection can look back at a price chart and determine the perfect entry and exit points. Whilst the above strategy may appear to be self-explanatory and relatively easy to follow, implementing it in real-time with real capital at risk is an entirely different animal. You would be well-advised to practice your trading skills on a demo account prior to putting any of your capital at risk.
When Should you Trade a Bearish Flag?
When deciding whether or not to trade a bearish flag there are certain factors that you should keep an eye out for. While none of these factors being present will guarantee success, they will help to ensure the best performance when trading and increase the statistical likelihood of success.
Firstly, you should ensure that you trade with the prevailing market trend: avoid using bearish flag patterns during a bull market. Secondly, bearish flags tend to perform best when they are closest to their yearly lows. You should try to identify flag patterns on down-trending stocks that are close or below their yearly lows. Finally, avoid trading flags that are short and narrow. The best performing flags will be those that are tall and wide and so those are the flags you should attempt to locate and trade.
Ideally, the flags should form and break out within three weeks. In the event that the flag fails to breakout during this time, it is advisable that you avoid trading this flag. We will discuss this further in the section below.
How Reliable is the Bearish Flag for Trading?
A common saying among members of the financial community is that past performance is not indicative of future results. Active traders would be well advised to commit this phrase to memory.
According to Thomas Bulkowski, author of the Encyclopaedia of Chart Patterns, when it comes to flag patterns, the bearish flag is statistically the most reliable flag pattern and enjoys the lowest failure rates. However, like all pattern formations, bearish flags are not immune to failure.
Whilst chart patterns certainly provide traders with a statistical advantage, they in no way guarantee a successful trade. If they did, the number of billionaires on the planet would begin to increase rapidly. Price movements are known to regularly deviate from potential patterns when trading and it is entirely possible that the price of a security may behave differently than the pattern may suggest. Traders should always remember to effectively manage their risk with stop-loss orders and proper capital allocation.
When trading bearish flags the length of time the pattern has taken to form should be taken into account. This is due to the fact that the longer the flag has taken to form the more likely it is to fail or experience a weak price move after the breakout. I would suggest trading flags that are more than three weeks long with caution. Ideally, traders will decline to trade them entirely.
Benefits of Trading with Bearish Flags
There are a number of benefits to trading with bearish flags. Since they are relatively straightforward patterns to trade when compared to some of their peers, they are ideal for novice traders who are looking to cut their teeth and develop their skills.
Further, their comparatively reliable nature means that, if properly identified, they require less risk to be taken on when trading and offer very attractive risk/reward ratios.
Risk Factors Associated with Bearish Flags
Risk is a recurring theme in any trading discussion and trading a bearish flag is certainly not without risk. One of the largest risks comes from the mechanics of the trade itself since in order to trade a bearish flag you will need to enter a short position. As many readers will know, entering a short position typically carries more risk than entering a long position as it will mean that, theoretically, your losses could be unlimited. For this reason, you should ensure that any short position is always protected by a strict stop-loss order.
You should also always be aware that no matter how perfect the trade setup may appear to be, price trends may always reverse and that price may not move in the way you anticipate that it will. It is important that the amount of capital you invest into any trade is in keeping with the principles of proper portion sizing and that you do not overcapitalize any individual position.
Get Educated on How To Trade Profitably
To learn how to properly identify, trade, and manage risk on any pattern in the stock market, you should start by getting properly educated and creating a back-tested system that uses defined points of criteria to let you know when to enter and exit a trade.