The theory of flags
Flags are my favorite technical formations. They have a trend confirmation character, are easy to recognize and grateful when you trade them correct
Ideal-typical flag:
A bullish flag is a massive, strong volume move followed by several days of sideway trading sessions to lower price action on much weaker volume followed by a second, sharp rally to new highs on accelerating volume again.
The first big Move: First of all, you have to check in which trend phase the market is trading. Flags used as continuation pattern should always and exclusively traded with the trend direction! There should be an evidence of a sharp advance, usually on heavy volume. A gap also can be seen as the “first big move”. This move usually represents the first leg (Flagpole) of a significant advance and the following flag is merely a pause.
Flagpole: The flagpole is the distance from the first move break to the high of the flag.
Flag: A flag is a sideway / light decline-move that slopes against the previous trend. If the previous move was up, then the flag would slope down (and vice versa for a downtrend). Ideal typically this decline/sideway move finds support and stops at the 38,2 fibo-retracement of the first big move.
Duration: Flags are applicable in all timeframes but the longer the timeframe, the better they are applicable. The reliability of patterns that are very shortterm are well debated since years. I made some good experiences in the short-term trading as well as in longterm trading.
Break: For a bullish flag, trading above its flag-upper-edge (resistance) signals that the previous move has resumed.
Volume: Volume should be heavy during the advance that forms the flagpole. Heavy volume provides legitimacy for the sudden and sharp move that creates the flagpole. An expansion of volume on the resistance break lends credence to the validity of the formation and the likelihood of continuation.
Targets: The target of a flag is the length of the flagpole. The technical target is derived by adding the height of the flag pole to the eventual breakout level at point.
In my former educational series (Basics of 1-2-3 Trading - https://www.tradingview.com/chart/EURUSD/Xjknpt4S-Introduction-into-1-2-3-Trading-Pattern/) I have illustrated the important entrypoint “2”, which is a pivot point in the market when you are trading the trend.
Reminder: Entry with 1-2-3-pattern:
A flag is very similar to this scheme and are a kind of adaption of this 1-2-3-theory.
So much to the theory. But what really happens with such a formation above all @ the flag edges?
One must make clear for it to himself how market participants operate and think
I try to illustrate this Market Psychology with the help of an example:
1. After the strong move and the first consolidation, the traded underlying rises once more to the former High, which now can perhaps be seen as a potential resistance.
2. At this level ( yellow “1”), the shorties lie in wait to fix that level because when the price dropped once at this level it could happen over again. Technically, they likely install their stop loss orders a tick above this level. They exspect falling prices, their probably take profit is the former Low
The traders who tried a longposition at the upper side with the first BIG MOVE are thinking: “Oh, my position went direct into the loss after opening. If the price reaches this entry-level again I will cover my position.
3. When the price dropped to the former low, traders who stood at the sideline could see a chance for buying that point (support) @ yellow “2”. The long-traders will install their stop loss orders a tick under this point with TP @ flags upper edge. Furthermore the shorties will cover their positions and also become buyers.
Long traders who did buy the first BIG MOVE and didn`t close their position (flat) at the yellow point “1” are thinking: “Oh shit, I had the chance to cover my position without loss. Now the position is again deep in loss..when we reach again the upper level, I will close my position this time.”
4. When the price increases to the former High, more and more shorties see that and will short this level (longs vice versa) ( Longs tend to close their positions there because of the strong resistance)
5. Every time the price reaches this levels more and more traders will join this game. @ the resistance, the supplyside is getting higher and higher meanwhile @ the support the demand is getting higher and higher. @ the support side we now see a support surplus, @ the resistance we see a supply surplus.
6. This procedure repeats to itself as long as to either the support or the resist breaks.
What happens then?
For example the flag gets triggered on the upper side (Break of the resistance):
With every tick above the illustrated resistance, the shorties are getting more and more cold feets because their positions will suffer a loss with every uptick. Traders who are flat up to this time think about going into the market with stop-buy orders, a tick above this level. (Break-out traders) Furthermore the shorties who have to cover their positions turn to buyers and strengthen the asks. The result of it is a strong upmove, a classical shortsqueeze.
Basics of Market-Techniques
Basically there are 3 kinds of traders in a market:
-Those who are positioned LONG – they exspect rising prices
-Those who are positioned SHORT – they exspect falling prices
-Those wo stand on the sideline – they are FLAT and waiting for a good entry
These three groups are responsible for the fact that a price determines, because they provide the offer and demand. From this fact there originates the important knowledge, that not news or external events make the price, but the three mentioned tradertypes .
Origin of a trend
From the knowlegde about the order book there originates again the knowlegde about forming a trend. At the moment, while the demand exceeds the supply, more buyers than sellers exist – the price will increase by the traders who are LONG positioned. In the following example, a big institution is on the buyside, that makes the price rise.
When the price has increased, one can read mostly in the press or www. Uninformed traders /newbies now take attention of the stock and also wakes interest in the share, perhaps they also buy some shares.
But what happens with the ones who are already invested and have already taken part so in the first movement?
Because their positions tend to be profitable, some of them will normally decide to take their profit and sell their shares. At this point we have on the one hand some newbies who want to buy and and the other hand many “early birds” who want to sell. In such situation we have a supply surplus. This ist he point, a HIGH appears – Such a HIGH to which we give the number “2” in the market technology originates exactly from this change.
The whole activity is observed of course still by the group no three which became attentive by the movement to the stock or has observed the market anyway. These stand still @ the sideline and are still flat
Now, the demand is lower than the offer what leads to falling proices. The market tips and is traded down.
What happens which these traders who have bought the HIGH from those which have sold her shares up there?
As a result oft he decreased market their positions are in the deficit - the one or other will decide to close their positions. They offer their shares again and stand on the supply side in the orderbook. Now this drop other traders adopt again and buy this share to a more favorable price again after or also for the first time because they are for example orientated technically.
Now more traders are ready again to buy, that means that the market will rise above the last HIGH. The traders who stood @ the sideline (flat) to find a market-technically-entrance are in the end responsible for that move.
And thus the whole play continues on and on till the trend breakes.
Trend break
The trend break occurs, when the market drops below the last LOW. Those market participants who prefer trend trading (swing) according to the market-technique place their stops under point “3” and will trail this stop accordingly. If the market drops below the last LOW, these stops lying there get triggered. With it the market drops even further and the play can begin again, only just then in the other direction.
Perhaps some of you (if u are a newbie) will recognize, why they made many bad trades in the history. The cause for it lies only in it reasonably that one makes a decision always on account of an available movement what is owed to the missing knowledge about trend construction. It would be better, one would position himself on account of a movement to be expected and not only during or even at the end of a movement.
The Movement
Now you have already read several times the word or concept „movement“. One understands by it a neuralgic point in which the course gets drive. This mostly happens in a point “2” – the last HIGH (respectively a “LOW” in a downtrend)
But why is he point „2“ so important? This arises from it because this point is valid as a special place of matching orders. At this point entrance orders, stop orders and entrance orders by position rotating meet and thereby originate a mostly fast movement which again leads to a new HIGH / LOW (new “2”)
The first trader is positioned short and his stop order will be executed at point „2“. When triggered, his stop order turns into a market order. Somebody stands on the other side and buys there the share and thereby originates a long order (in downward trend vice versa). Because the trader has recognized his position was wrong, he switchs his position i.e. he buys again on which the second long order originates in the book. Therefore the same trader occurs twice in the orderbook.
The third trader was up to now FLAT, is market-technically orientated, recognizes the point “2” and also opens there a LONG position. All that proves taken together the so called domino-effect which signs for the market-technically movement responibly. Therefore it might be clear that the experienced market technical always searches himself a point “2” for his entry.
The duty of a market-technical trader is to proceed always on the search for intact trends and to lay his focus on a striking point "2". Nevertheless the freestyle of technical trading is to realize in which market phase the stock is trading at the moment. Much more important than the entry is the “WHERE”. Is the market just in a MOVEMENT or is he in a corrective mode. Or has the market just ended his correction and a new movement begins?
Anyway, every trade is only as good as the belonging to its market phase because with an accidental winning trade is not sustainable. At this point we come to the biggest challenge in stock trading: WAITING!
Who cannot wait for the right market phase will not earn money in the long term. The main thing of technical trading exists of two steps:
- If we have found a signal – a point „2“ in an intact trend – it is the duty to have a look at higher time frames. If the market phase is also in an intact trend (1-2-3) and there optimally from a correction to their last point “2”, the signal has a very good CRR. With all market-technical entries the higher market phase must be considered because the Big Players will give the direction.
The Market-Technique offers three kinds of trading-patterns:
1-2-3-Trading (Trading the Trend)
Trading the Move(ment)
Trading the Break-Out
For all these three opportunities, the “1-2-3 counting” is essential.
1-2-3-Trading (Trading the Trend)
As mentioned above Point „2“ is the pivot of Trend-Trading. At or near this point, you open your position. Your Stop Loss is based near the point “3”.
Extension of 1-2-3 pattern referring to Joes Ross`s “Ross-Hook”
To minimize the risk of false-breakouts you can use the Retest of the Breakout as your entry-level to open a position. A buy stop is placed one tick above the highest high of the Ross Hook. Short trades: A sell stop is placed one tick below the lowest low of the Ross Hook
More Infos
http://www.oxfordstrat.com/trading-strategies/ross-hook-1/
http://www.trading-books.com/ross-hook.html
Beispiel 1-2-3:
Bsp. Rosshaken: