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
The chart below is of Bendigo Bank, BEN, from March to early May 2007. The share price gapped up significantly after the announcement of a friendly takeover from Bank of Queensland, BOQ.
In the above chart notice the yellow area is the flagpole. This occurred due to the fact the board had announced the rejection of the $2.7 billion takeover offer. On the three-day formation of the flagpole notice the higher volume highlighted in aqua. Since then the share price has been consolidating in more of a pennant formation then a flag formation.
If the break out occurs on the downside, the target price is the height of the 'yellow' flagpole subtracted from the share price break. This is highlighted as the grey area. Notice that the theoretical target price is suspiciously close to the share price prior to the announcement of the merger announcement.
Please note, it is possible for a breakout to occur on the upside, especially if another bid comes in for the group.
