Flag Tutorial

Start with the Introduction and work your way through to mastering all the basics you need for trading Flags.

  Introduction to Flag Trading
  • Introduction to Flag-Trader
  • Flag Patterns
  • Trending Stocks
  • Finding Flags and Trending Stocks
 

Trending Stocks

We've all heard the expression "The Trend is your Friend". Well, although it's a little hackneyed now, the basic premise is true. If you can learn how to trade with a trend, and it's ludicrously simple to do so, then you are well on the way to trading consistently and successfully. The next step is to discover how to find trending stocks, and what particular patterns you need to trade.

What is a trend?

A trend can be defined in any way you desire, however, it helps to have a clear definition in your mind so you can easily interpret when a trend is occurring.

Uptrend

An uptrend can be described as a sequence of higher lows in conjunction with higher highs.

Downtrend

A downtrend can be described as a sequence of lower highs in conjunction with lower lows.

Some people define an uptrend as when the closing price is above the moving average (of a specific period), and a downtrend when the closing price is below the specific moving average.

I don't use moving averages of price movement to define trend, nor to source trending stocks. There are inherent flaws with using moving averages, which we'll discuss below.

In my workshops I ask my delegates how they find trending stocks, and the two most common answers I hear relate to moving averages and fundamental filters. From those two answers I already know that the person concerned doesn't find trending stocks, purely because moving averages and fundamental filters don't find trending stocks!

So first things first, let's identify some trending stocks, and clarify why they're trending. For this, we'll need the use of real price charts.

Chart 1: an up-trending stock

As you can see, the stock is rising and appears to keep bouncing off the imaginary trendline at the points B. This trendline is providing support for the stock. Typically we expect volume to rise as the price hits the trendline and bounces off it, confirming the supporting action. Notice that with an uptrend, we draw the trendline to join up the lows.

Sooner or later the uptrend has to be broken and the stock will retrace downwards. The beauty of using a trendline is that when the price breaks through it, we can define the trend as being over.

So far so good. Let's now look at a down-trending stock.

Chart 2: a down-trending stock

Here is the opposite case. The stock is falling and appears to keep bouncing off the imaginary trendline at the points B. This trendline is providing resistance for the stock. Typically we expect volume to rise as the price hits the trendline and bounces off it, confirming the resistance action. Notice that with a downtrend, we draw the trendline to join up the highs.

Sooner or later the downtrend has to be broken and the stock will retrace upwards. By using a trendline we know that when the price breaks through it, we can define the trend as being over.

If this sounds easy, the reason is because it is easy! If you're looking for something more complex, then I'll show you moving averages and why they don't work for defining trends. You want your interpretations of trend to be made easily, because it helps your decision making process when it comes to actual trading. If your interpretation of a chart isn't clear, your trading will be equally as unclear, which will only lead to inconsistent, bad and unsuccessful trading.

The Myth of Moving Averages

Moving Averages are the most widely known and used technical indicators. A moving average is simply the average closing price of a period of bars on a price chart. On a daily chart, a 20 period moving average is the average of the last 20 days prices. Tomorrow's moving average will include what happened today (but not tomorrow) and similarly, today's moving average includes what happened yesterday (but not today). Moving Averages are useful for the way in which they smooth price action and they are perceived by many to be good indicators of trend.

The most popular way of using moving averages is to have one short term and one longer term. When the short moving average rises up through the longer term moving average, this is a bullish signal. When the short term moving averages falls down through the longer term moving average, then this is seen as a bearish sign.

The problem is that this method is only remotely relevant with trending stocks. And if we can't readily find trending stocks, then there's no merit in it whatsoever. The other problem with it is that by the time the short MA crosses the longer MA, the stock price may well have plummeted or rocketed ahead of time. In other words, a moving average is a lagging indicator, and if the lag is too long, then the stock moves ahead without you. If the lag is too short, then there are no smoothing benefits to using the moving averages at all.

So, what if the stock is rangebound, or zig-zagging all over the place? Well, then moving averages aren't going to be any use to you.7

Chart 3: moving averages example

In the above chart, using moving average crossovers, the sell signal occurs a full $40.00 below the high of the stock. That's not exactly very efficient, and in the meantime the stock has been up and down in vicious swings that would send us diving for the Pepto-Bismol!

So, moving averages are best used when the security is trending. See below how confusing the signals become when the stock is rangebound.

Chart 4: moving averages double crossovers

Each "D" stands for "Double Crossover" whereby the moving average sends a long and short signal (or short then long signal) in quick succession, resulting in losses to our account. If this happens continually, then our accounts can be eroded pretty fast! Do you now see how moving averages could be something of a myth?

Notice below that we're back into a trending situation, this time the trend is downward, there are fewer double crossovers and the position is a little clearer. But even here, (a) we still have those confusing double crossovers and (b) we still need to understand how to find trending stocks.

Chart 5: moving averages on a trending stock

Trendlines

The easiest way to identify a trend is if you can draw a trendline. Trendlines are far more reliable and simple to use than moving averages.

With an uptrend, the easiest way to trade is if you wait for the trendline to be hit and the price bar to bounce upwards off it, continuing the trend.

With a downtrend, the easiest way to trade is if you wait for the trendline to be hit and the price bar to bounce downwards off it, continuing the trend.

A break of the trendline, particularly with rising volume, may signify the end of that trend.

Chart 6: Trendlines

If the trendline is broken, particularly if it's broken with an increase in trading volume, then we know the trend is over and we can go and play another stock. The advantage is that we exit almost immediately and the rule is very straightforward. With a moving average we may have to wait several more days until the lines cross over, and by that time we could be sitting on significant losses.

Trending stocks tend to move in steps. These steps involve thrusting moves followed by consolidation. These moves can be referred to as steps, or in some cases, flags. A flag is distinguished by the significant thrusting move prior to the flag forming.