How You Can Use the Flag Chart Pattern for Your Options Trades
The big advantage with flag chart patterns, is that they allow you to anticipate price targets for the underlying stock, commodity, currency or index that you’re trading options on. This one feature alone can allow you to achieve maximum profit potential from the leverage you get with options.
The flag chart pattern is formed by approximately 5-20 trading sessions. These sessions may be observed on both the daily or weekly charts and consequently, used for short or longer term option strategies. It is called a “flag pattern” because when you draw trend lines over both sides of the bars or candlesticks, it looks like a parallelogram that slopes in the opposite direction to the prevailing trend. This prevailing trend may be either upwards or downwards.
When you see a flag chart pattern form, it means that for now, the stock is undergoing a short period of price consolidation, but within the bigger picture of its overall strong trend. It’s just taking a short rest before continuing its overall direction. It may appear to be a reversal at first but it is really just gathering strength for the next big move. It’s important that we don’t acknowledge a flag chart pattern until a breakout occurs which validates the fact that it was just that and not a reversal. The breakout must continue the price action in the same direction of the overall larger trend.
The Flag Chart Pattern and Fibonacci
Flag chart patterns can be used very effectively in conjunction with Fibonacci retracements. The reason you apply fibonacci retracement levels is, that you want to ensure that the temporary reversal that makes up the flag formation is not overdone. If it retraces more than the 38.2 percent fibonacci level then it is more likely an indication that the overall trend is weakening. This in turn means that the flag pattern may not be so reliable for predicting the target price as described above.
In the charts below, we can see some examples of how the flag pattern reverses only as far as the 38.2 percent level before the price action continues in the overall direction. If the flag chart pattern extended to say 50 percent retracement then we would not be so confident that the continuation target will be met.
Note how the price target is set. You draw a line from the beginning of the prevailing trend to the first peak or trough (depending on whether it’s an up trend or down trend) in the flag pattern . This line is called the “flagpole”. The parallelogram forms the ‘flag’. Once the breakout occurs, you then copy the flagpole line onto the last extremity of the flag. This last line will give you the expected price target for the underlying.
All breakouts must be supported by trading volume. If volume is less than for the previous session or lower than the yearly average, then the breakout may not be valid. We should also expect to see lower volume during the period while the flag pattern is forming. This is because the trading range is reduced and the price volatilty is falling out of the stock. But once the pattern is cleared and price continues in the direction of the prevailing trend, volume should increase.
It’s worth highlighting again, that the flag chart pattern works just as effectively on the weekly chart as it does on the daily. When trading the weekly patterns we should purchase longer dated option contracts, or a number of shorter dated ones, as the price target will take longer to achieve. With weekly chart patterns, you should look at how long the flag pole took to form and allow the same for the price target to be achieved.
Paying attention to flag chart patterns in connection with the confirmation that fibonacci retracements provide can lead to some of the most profitable option trades you may experience.