Candlesticks - Bear Flag Formation

By definition, the bear flag formation is a bearish or shorting trading pattern and is as effective as its counterpart, the bull flag formation. Because markets tend to go down by the lift (fall rapidly) and climb  up by the escalator (mostly on a step by step pace), a confirmed bear flag formation can provide a strong return. When markets turn south, they fall fast.

We have previously covered the "bullish" bull flag formation and employed the pattern to great effect. Like many of the more well-known trading patterns, this has a mirror image called the bear flag formation.

Characteristics of a Bear Flag Formation

Flagpole

The flagpole will usually develop because of an unexpected piece of news such as unfavourable company earnings announcements; basically news that will send the price of a share lower. Volume should be noticeably higher as the flagpole develops.

Flag

After a sudden price slippage and the immediacy of the negative news subsides, the share price often consolidates into a so-called flag formation. In tandem with the levelling out of the share price, the trading volume will also fall back to more normal and sustainable levels. It is also interesting to note that although it is called a "flag", the shape is more often pennant shape, as in the example below.

Breakout

Once the stock breaks out of this 'flag' formation, short-term trading theory suggest that the target price - or the price the share will fall to - will be equal to the same dollar amount of the first fall, subtracted from the lower break point of the flag formation. Past trading history of the bear flag formation shows that an increase in volume normally accompanies this break. Moreover, the bear flagpole formation is often found within a larger downtrend per se, as the falling share price might have gone too far too quickly, and is in need of a period of consolidation before continuing the down trend.

Practical Example - Leighton Holdings 2011

The chart below is of Leighton Holdings Limited (LEI), from March to May 2011. The share price gapped down after the announcement of a company profit downgrade in March before going into a trading halt in April where the company announced a $750 million capital raising, offering shares at $22.50. This was a substantial discount to the $29 closing price before the trading halt.

In the above chart notice the green area is the flagpole with the yellow area showing the consolidation-like phase. Note the higher volume below with the flagpole formation. Mostly it is more of a pennant formation then a flag formation.

If the break out occurs on the downside, the theoretical target price is the height of the 'green' flagpole subtracted from the share price break. In this case the capital raising offer over rode the theory.