Flag patterns are commonly used to indicate the continuation of an uptrend. Often they occur after a break-out and represent a brief pause in momentum before the eventual continuation of the rally upwards. The also appear in downtrends as well (remember in FX trading you just need to flip which cross currency is the base currency and the chart will be the inverse).
How to spot a flag pattern
The first thing that needs to be present for a flag pattern to be formed is a steep rise in a cross currency, as mentioned before this is often after an initial breakout. This steep rise forms the flag pole. For those nautically inclined, it is sometimes referred to as the mast rather than the flag pole.
A flag begins to from when the upwards price movement takes a small pause. At some point prices begin to move in a horizontal director or, as shown in the chart below, in a direction opposite to the main trend. This is where the flag pattern is formed as clearly shown in the chart below. During this stage of an uptrend price movements are taking a short-break as some people take profits.
It is important that the flag is an area of low price volatility relative to the initial breakout, the lower the price volatility the higher the expectation of a continuation of this pattern. This makes sense as a short low variance rest period for the price action means that sellers have not totally overwhelmed buyers.
Traders will generally enter long (buy) when the price pattern breaks above the flag as illustrated in the chart above. Only once the price has broken above the upper flag line should you enter this trade as this is confirmation of the pattern.
Tips on trading the flag pattern
Often multiple flags are formed on a particular uptrend, especially if it is a strong movement. Whilst the initial flag pattern is generally the most profitable, all subsequent flag patterns can be traded as well. This is shown in the chart below.
The flag pattern is the similar to a pennant pattern the only difference being in the formation of the flag. Instead of parallel trendlines in the flag region (as pictured above) the pennant patter has converging trendlines.
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