In technical analysis, traders analyze a wide variety of chart patterns in an attempt to predict and profit from the future price movements of individual stocks. One such pattern is known as a bull flag. Here’s what traders should know about bull flags, how they work and how to trade them.
What Is a Bull Flag?
A bull flag is a chart pattern that emerges when a stock experiences a sudden increase in prices followed by a period of consolidation. During this period, the price typically trends slightly downward, though both its highs and lows will be significantly higher than they were prior to the price surge.
The bull flag is named for its appearance on a stock price chart. The initial upswing forms a distinctive flagpole in which prices seem to rise in a more or less straight line. Two parallel lines, tracing the narrower high and low marks during the consolidation, then emerge at a slight downward angle away from the flagpole. The resulting formation takes on the appearance of a flag when these lines are drawn on the chart.
The end of a true bull flag comes when the stock breaks out of the narrow range it has been trading in during the consolidation period and begins to move upward again. This confirms market bullishness and often indicates the beginning of a renewed price surge. If the stock breaks out by moving down, the bull flag is considered invalid.
It’s worth noting that bull flags can take several different forms. The typical flag described above involves a modest selloff with prices remaining well above their previous levels. In some cases, however, the price will remain almost completely flat, skipping this brief downtrend altogether.
Another type of bull flag is known as a bull pennant. In this type of bull flag, the stock’s highs and lows begin moving closer together, causing the chart to form a triangular pattern coming off of the flagpole. As the two converge, a breakout in one direction or the other becomes imminent. Like a bull flag, the resulting breakout can send the stock either higher or lower.
How Do You Read a Bull Flag?
Once a bull flag pattern has set in, traders must understand how to read it in order to profit from it. The first thing to understand about a bull flag is that it is fundamentally a continuation pattern. In other words, a bull flag can confirm a bullish pattern, but only if certain conditions are met.
During a bull flag, the stock may lose up to 50 percent of the value it gained during the initial run. The ideal level of retracement for a classic bull flag, however, is considered to be 38.2 percent. It should be noted that this is a rough guideline, as very few bull flags will end at such a precise level.
In order for a bull flag to become complete, the stock must break through the resistance levels it has been testing on the high side. This confirms the bullish pattern, indicating an opportunity to buy and profit from a continued increase in share prices.
It’s also worth noting that bull flags often coincide with an increase in trading volume. This occurs as prior shareholders take profits and strong bulls continue to buy at elevated prices. Higher volume often supports an upward breakout, though in some cases the stock will continue to trend higher in spite of lighter volumes.
Is a Bull Flag Bullish or Bearish?
Classically, a bull flag is assumed to be bullish in nature. This is because the prices of the underlying asset consolidate well above their previous holding levels after a sharp rise.
During this period, buyers typically take a break from aggressive acquisitions, and some may engage in profit-taking. Investors with long positions in the stock may also decide to sell to take advantage of the suddenly higher prices.
This selling, however, does not imply bearishness on the stock. Rather, it remains at a modest level with a firm price support from ongoing buying activity. If the price begins to drop drastically, this represents a pullback that breaks the bull flag pattern. In this case, the trend going forward can turn bearish.
How Reliable Is a Bull Flag Pattern?
While widely used in technical analysis, the bull flag pattern is far from a guarantee that a stock’s upward trend will continue.
The bull flag pattern emerges during a period of consolidation following a sudden spike in a stock’s price. In order for the bull flag to be confirmed, the price must break out of this consolidation phase in the upward direction.
As with all forms of technical analysis, bull flags are also subject to assumptions about the predictability of short-term market trends.
Technical analysis holds that identifiable patterns, including bull flags, can indicate the direction in which a stock will tend to move. This assumption rejects efficient market hypothesis and is therefore controversial among investing and finance professionals.
Can a Bull Flag Be Bearish?
While the bull flag pattern is always considered bullish, there is an opposite pattern called a bear flag that indicates a continuation of a downward price trend.
A bear flag emerges when sellers consolidate after a sharp decline in the price of a stock. In a bear flag, prices trend slightly upward during this period, and a breakout that sends prices lower confirms the bear trend.
Why Is a Bull Flag Bullish?
A bull flag is bullish because it establishes a continuing trend of upward prices.
Assuming a bull flag completes by breaking out toward higher prices, the pattern confirms bullish market sentiment strong enough to withstand a period of consolidation and profit-taking.
By breaking through further resistance levels on the way up, a classic bull flag pattern indicates that the market as a whole is enthusiastic about the stock and that the initial price surge wasn’t a brief anomaly.
What Is a Failed Bull Flag?
A failed bull flag occurs when the flag breaks above its previous resistance level but then reverses. The reversal can bring the price back into the bull flag range or mark the beginning of a more bearish downward trend.
While this factor isn’t always present, failed bull flags may be indicated by low trading volume as the price breaks out from the bull flag pattern. This light trading may suggest hesitancy on the part of investors, potentially setting the stock up for a failed bull flag.
Failed bull flags can also occur due to broader market factors that have little or nothing to do with the stock being traded. Negative macroeconomic news, for example, may cause the entire market to fall, bringing the price of the stock down shortly after it breaks out of a bull flag.
How to Trade a Bull Flag
There are two primary ways to trade a bull flag. The first and most reliable is to buy immediately after the stock breaks out of the flag and begins to move higher. At this point, the bull trend is confirmed and traders won’t have to worry as much about the potential for a breakout on the low side. Those with very high risk tolerances, however, may choose to buy during the bull flag itself.
In some cases, it may also be worth watching stocks that seem to have already gone through a successful bull flag. While the breakout from a bull flag will continue with another price increase, this second increase is rarely as linear as the one that forms the flagpole. As such, the stock may move slightly lower after the breakout and present traders with a new buying opportunity.
Traders operating on short time horizons may also decide to employ stop losses when trading a bull flag. By setting a stop loss at a level that would imply a downward reversal, traders can minimize their losses when bull flags fail.
It’s also important to use multiple technical indicators to confirm bullish patterns. While a bull flag can be a fairly strong indicator of continued bullishness, checking it against other tools like the relative strength index and moving averages may help to shed more light on the strength and viability of the bull trend.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.