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Friday, December 14, 2007

BEARISH FLAG PATTERN – Part 1: Formation

Bearish Flag is a short term bearish continuation pattern that occurs during a downtrend, indicating a pause / small consolidation before continuing its downward moves.
This pattern normally appears following a sharp price decrease on high volume.

The Formation of Bearish Flag

Bearish Flag Pattern is usually preceded by a very steep (almost vertical) decrease in price on heavy volume. This steep price decrease makes the “Flagpole” of the pattern.
The sharp decline in price may occur due to negative market sentiments toward unfavorable events / developments, such as negative earning surprises, downward guidance, fraud / court cases, etc.

After the sharp decrease, the price movement is then contained within two parallel lines, forming a small rectangle “Flag” shape, on decreasing volume.
The rectangle flag is often slightly sloping upward, although it could be horizontal as well.
This flag represents a brief pause / consolidation in the midst of a downtrend before resuming its downward movement.

The completion of the pattern occurs when prices break to the downside through the support level (i.e. lower parallel line) of the Flag with a spike in volume. This would mark the resumption of the original downtrend.

The Psychology Behind Bearish Flag Pattern
A Bearish Flag pattern takes place because prices seldom decline sharply in a straight line for an extended period. Hence, during a sharp price movement, prices will typically take brief pause periods to "catch their breath" before continuing their move.

During the 1st stage of the Bearish Flag pattern (Flagpole part), as a result of negative market reactions toward some unfavorable events / developments (e.g. negative earnings surprises, downward guidance, etc.), prices keep on dropping sharply as nervous sellers and new short sellers who were caught-up in the euphoria at that moment, are willing to sell at even lower prices.

As the prices drop, some early sellers who have sold short the stock at higher levels would begin to cover their short position. In addition, some investors might also start bargain-hunting. At this point, the 2nd stage of the Bearish Flag pattern begins (i.e. the Flag part).
At first, most of the stocks bought by the early sellers were easily absorbed by nervous new sellers, since the news and market sentiments are still very negative. Nevertheless, as time passes, the selling pressures subside and more investors come for bargain hunting. Consequently, the prices begin to climb up gradually, but the increase is slow and volume is diminishing, as the bearish sentiment is actually still very strong.

After some time, just as it starts to look as if a real increase is underway, new negative news come out. As a result, the price begin to collapse again and break out through the lower line of the Flag with a surge in volume, as new sellers now overwhelm those bargain hunting.
In the following days, there might be more unfavorable news / comments or less optimistic earnings forecast coming, leading the prices to drop even lower.

To be continued to Part 2: Important Characteristics of Bearish Flag pattern.

To read about other chart patterns, go to: Learning Charts Patterns.

Related Topics:
* Learning Candlestick Charts
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks