How to spot these two kinds of continuations.
Once a trend is established, a technical analyst would ride the trend till it reverses. As stocks do not usually rise in one straight line, they may take time off from their original move and consolidate in a sideways pattern, before continuing with their initial trend.
This sideways movement of stocks may resemble a Flag or a Pennant. These patterns serve two purposes. If it reassures that the original trend is on, one can remain invested in the stock. The second is when the price breaks out of these patterns on the higher side; it gives a new opportunity to enter the stock. (Click here for charts)
The only difference between the two patterns is that a Flag resembles a rectangle marked by two parallel trend lines that tend to slope against the prevailing trend. The Pennant, however, is identified by two converging trend lines and resembles a small symmetrical triangle.
Traits of the Ideal Pattern
Sharp Rally: Formation of a Flag or Pennant pattern starts with a sharp move upside and with significant volumes. This sharp rise becomes the Pole of the Flag or Pennant.
Flag: A flag is a small and narrow rectangle pattern that slopes against the previous trend. If the previous move was up, then the flag would slope down. If the move was down, then the flag would slope up. The Flag can be drawn by taking the help of two trend lines which adjoins the highs and lows made during consolidation of the price.
In the Bajaj Hindustan chart below , note that while the original trend was up, the Flag formation is sloping downward. A long-term investor would have remained invested during that flag formation.
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Pennant: A Pennant is like a small symmetrical triangle that begins wide and converges as the pattern matures. It contains lower highs and higher lows. The slope is usually neutral.
In the Nocil chart below, notice the convergence as the Pennant matures.
Breakout: For a bullish Flag or Pennant, a break above the trendline resistance signals that the previous advance has resumed. Note the sharp appreciation seen, in both Bajaj Hindustan and Nocil charts, after the breakout.
Volume: Volumes should be heavy during the advance or decline that forms the flagpole. Heavy volume provides legitimacy for the sudden and sharp move that creates the flagpole. Usually volumes get moderate during the formation of Flag and Pennant. During the break out, the volume rises again.
Volumes are high in both cases, when the Pole of the Flag and the Pennant are made in the case of Bajaj Hindustan and Nocil, respectively. They dip during consolidation and rise again during breakout.
Targets: In an up-trend, the targeted move is measured from the bottom of the Pole to the highest point recorded in the Flag or Pennant pattern. The move is then projected up from the point of breakout , to arrive at the target.
In the case of Bajaj Hindustan, the Pole formation began from June 25, 2004, and was completed on February 11, 2005, gaining Rs 143 in the process. The Flag lasted from February 11, 2005, till June 24, 2005. The target set for Bajaj Hindustan was Rs 150 (Point of break out) plus Rs 143 ( size of Pole), which was Rs 293. This target was reached during the week ending December 23, 2005.
While trying to identify Flag and Pennant patterns, you will have to be slightly imaginative It's difficult to find replicas of the terms. Traders would find Pennants more useful, as they have a shorter time scale and show quicker results. Sometimes, when patterns are not so clear on a daily chart, try taking a look at the weekly chart, which may be telling you a story.
The writer is director and head of research, Anagram Capital