Trading flags and pennants by the numbers

In the forex trading market, a sharp breakout by a currency pair sometimes indicates more to come. Ed Ponsi, in his excellent manual Forex Patterns & Probabilities (Wiley Trading, 2007), likens it to galloping up ten flights of stairs in that one is likely to pause at the halfway point for a breather. In the same manner, when a currency pair runs up the flagpole and then pauses to consolidate, it can signal a trend continuation with another sharp movement to come, and a market entry for alert traders.

The technique has become so widely utilized that the possibility of a self-fulfilling prophecy cannot be denied. Nevertheless, traders are warned against leaning without question upon any trading technique, particularly in this current volatile market. Good management is built into this strategy and traders are encouraged to heed it.

When a currency pair moves sharply on an intra-day chart, the resulting long candles grouped closely together form what’s called a flagpole. Note that the direction of the movement, bullish or bearish, is unimportant; what matters is the strength, momentum, and therefore the credibility of the move, with any hint of indecision disqualifying it from the definition.

For the purposes of this trading strategy, there is no practical difference between a flag and a pennant, both of which are formed by the consolidation that occurs after the flagpole is complete. For the record, a pennant is triangular in shape with support and resistance lines both drawn diagonally and slanting toward a common point, while a flag forms a price channel angling in the opposite direction to the flagpole. If the original movement is bullish, then the flag angles down, whereas if the flagpole is bearish, the flag angles up. After the consolidation is complete, the original movement can be expected to continue, hopefully as sharply and for the same distance as before.

The first step in trading flags and pennants by the numbers is to calculate the length of the flagpole. Note the one-hour chart below of the EUR/GBP, an excellent pair for this technique due to its generous quantity of sharp moves:

The bearish flagpole from 0.7840, marked at the top with a thick red horizontal line, to the bottom of the flagpole at 0.7768, the uppermost of the two thin red lines, is 72 pips. The trader preparing to work this chart formation calculates 10% of that move, in this case seven pips, and adds that to the final end of the flagpole to calculate the entry point, in this example 0.7761, marked by the lower of the two thin red lines. Note that, in this difficult market, the end of the flagpole has been conservatively calculated from the close, not from the low.

For this strategy, the stop is originally placed above the entry point at a distance 25% of the length of the flagpole. In this example, 25% of 72 pips equals 18 pips above the entry point at 0.7761 for a stop at 0.7779. During such a trade and, again, in this current market, a trailing stop would be appropriate; as an alternative, the stop can be moved manually to follow the price action and lock in profits.