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Strategy III: Flags
Even in a prolonged up-trend, a stock does not move up in a smooth and steady path: it usually moves up significantly, rests for a while in a continuation pattern, and then continues further up. "Flags" are typical continuation patterns. If one can identify a flag formation and locate a good entry level, one can often make a handsome profit without taking much risk.
Figure 5. BUD breaks out strongly to 45.12 with large volume at the opening of 2/20/2001. This part forms the "pole" of the bullish flag. Then it temporarily runs out of steam and drops back to 44.22, a level still higher than the pre-breakout level of 44. The strategy is to buy the stock near 44.22 and hope to sell it at 45 or higher. It is important to enter a stop loss order to sell the stock at 43.80. This prevents a loss if it turns down to a level lower than the pre-breakout level.
In the above "Bullish Flag" figure, the stock price is in a general up trend and it breaks out with large volume on 02/20/2001. Then it drops back to a level that is a bit higher than the high of the pre-breakout range. Traders who missed the opportunity to buy the stock just at the time of the breakout on 02/20/2001 now have another chance to get in, because it is likely that many investors will buy the stock and drive its price up. The 02/20/2001 breakout can be seen as the "pole" of the flag. The optimal trading strategy is to buy the stock near the lower edge of the flag and sell it at the upper edge to make a profit. If the stock price, instead of going up, drops down below the high of the pre-breakout range, one must sell the stock immediately to cut loss.
Figure 6. CORV breaks down strongly to 14 with large volume right after the opening of 2/16/2001. This part forms the "pole" of the inverted bearish flag. Then it temporarily rises back to 15.76, a level still lower than the pre-break level of 15.93. The strategy is to short the stock near 15.76 and hope to buy it back at 14 or lower. It is important to enter a stop loss cover order to buy the stock at 15.95, so that one is protected if it comes back to a level higher than the pre-breakout level.
The bearish flag trading strategy is just the opposite of the Bullish flag. In the above "Bearish Flag" figure, the stock price is in a general down trend, breaking down with large volume on 02/16/2001. Then, it bounces back to a level still a bit lower than the low of the pre-breakout range. Traders who missed the opportunity to short the stock just after the breakout on 02/16/2001 now have another chance to do it, for this time it is likely that many traders will sell the stock, driving its price down. The breakout on 02/16/2001 can be seen as the "pole" of the inverted flag. Here, the optimal trading strategy is to short the stock near the higher edge of the inverted flag and cover it at the lower edge to make a profit. If the stock price, instead of going down, rises above the low of the pre-breakout range, one must buy the stock back immediately to cover loss.
As Tradetrek.com computers monitor the market data stream, we constantly search the entire market for Flag trading opportunities, which we immediately display at the "Day Trading Center." For both Flag Trading Strategies, we provide "the optimal entry and cut-loss levels" for the traders reference. The levels are derived based on a great number of historical back tests such that the traders who follow those rules would achieve optimal returns with minimum risks. Because it is very difficult to calculate an optimal profit target, we do not provide one. There are a few things that a day trader can do here. One useful reference is the average daily price range. In a single trading day, the trader should not expect a profit much bigger than the size of the average daily price range. If a bullish flag trade is already making a profit comparable to the average daily price range, it is time to unwind the trade. The upper edge (or the top of the "pole") is also a good exit point; the trader can buy the stock at the lower edge and sell it at the upper edge to make a profit. The trader can also choose to successively raise the stop loss level if the trade makes more and more money. In this way, he can protect the profits and keep the opportunities open for more gains.
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