time, then look elsewhere for anothertrade.To assess how steep the price rise leading to the formation is, I calculatedthe average for the chart patterns. Both flags and pennants have rises near20%, as measured from the low at the trend start to the highest high in theformation. I include these values in Table 14.3 because it is important to selectflags and pennants that form after a large, quick price move.A similar move, as you would expect, completes after the breakout. Flags(19%) and pennants (21%) show rises that almost exactly match the gain leading to the formation. As such, these formations live up to the nickname of halfmast formations (they mark the halfway point).Since the numbers are averages, it pays to check what the most likely riseis by using a frequency distribution of the gains. For both flags and pennants,the most common rise is in the 15% to 20% range, about where you wouldexpect.The measure rule, which says that the move after a flag or pennant completes will meet or exceed the trend leading to it, succeeds 63% of the time for
Where in the yearly price range do flags and pennants in a declining pricetrend occur? Both types typically form in the center third of the range, suggesting that prices are near the yearly high then begin heading lower. As theytumble into the center third of the yearly price range, a flag or pennant forms.Then, after the formation completes, prices continue lower.The average trend duration, at 50 days for flags and 52 days for pennants,needs explaining. It is the average time from the beginning of the price trendto the end. It is measured from the nearest minor high before the formationforms to the minor low afterward. Where a trend starts and where it ends issometimes difficult to ascertain, so I adopted the minor high-low scheme butallow some variation when necessary.The average decline leading to a formation is 18% for flags and 17% forpennants. It is measured from the highest price where the trend begins to thelowest price at the start of the formation. The decline after a formation completes is similar (17%) for both formation types.Taken together, we discover that both chart patterns appear to form inthe center of a decline (roughly 17% on either side) that occurs over about 6weeks, on average. Such a large decline in such a short time suggests a profitopportunity. Trading tactics are discussed in the next section.The most likely decline is 15% (measured from the high at the end of theformation to the trend low) for flags and 25% for pennants. Although the pennant value is large, it simply means that there are more samples in the 25%range but the prior ranges have a fair number of samples, too. The many smallnumbers pull the overall average downward.
Table 14.4
Statistics for Flags and Pennants When Price Trend Is DecliningDescription
Flags
Pennants
Percentage beginning near 12-monthprice low (L), center (C), or high (H)
L24%, C60%, H1 7%
L23%, C66%, H11%
Price trend duration
50 days
52 days
Average decline leading to formation
18%
17%
Average decline after formation
17%
17%
Most likely decline after formation
15%
25%
Of those succeeding, numbermeeting or exceeding price target(measure rule)
61%
52%
224
Flags and Pennants
Sample Trade
The measure rule, in which the price trend after a formation meets orexceeds the prior trend, is met 61% and 52% of the time for flags and pennantsin a downtrend, respectively. I consider values over 80% to be reliable so theseresults fall short. Most alarming is that pennants perform so poorly. If you areconsidering trading a pennant in a declining price trend, be aware that prices
225
Murphy Oil Corp. (Petroleum (Integrated), NYSE, MUR)
may not reach the target.
Trading TacticsTable 14.5 shows trading tactics for flags and pennants. Consult Figure 14.8 asI review the tactics listed in Table 14.5. The measure rule gauges the minimumprice move. It is the same for both flags and pennants. First, determine wherethe trend begins, which is usually the minor high (for downtrends) or low (foruptrends) preceding the formation. Figure 14.8 shows the trend beginning atpoint A. Subtract the low at the formation start (point B at 42 3/4) from point A(47'/z), giving a difference of 43/4. Subtract the difference from the high at theformation end (point C at 43) to give the target price of 381/4. Prices reach thetarget 13 trading days after they move below the formation trendline.When trading flags and pennants, you must first be sure you have a validformation. Use the identification guidelines outlined in Table 14.1 to ensurethat you have correctly identified a flag or pennant.Use the measure rule to gauge the amount of profit likely from the tradeand weigh the amount of profit against the possible risk of failure. Look for
support and resistance levels where price trends were repulsed in the past.Many times prices will pause or turn around at these junctions. These valuesbecome the risk points for a trade. You can compare the risk with the rewardby computing the current price with the measure rule target and the first orsecond level of support or resistance. A ratio of reward to risk should be fourto one (or higher) for highly profitable trades.For the stock shown in Figure 14.8, the potential reward is 43/4 (that is, 43- 38V4). The first resistance level is at 44 and there is another at 45 (assumingthe trade goes against you and prices rise). The risk is one or two, that is, 44 43 or 45-43. The ratio, at 4.75 to 1, suggests this formation is worth trading,
Table 14.5Trading Tactics for Flags and PennantsTrading Tactic
Explanation
Measure rule
Calculate the price difference between the start of the trend and theformation. Prices should move at least this amount above (if in anuptrend) or below (for downtrends) the end of the formation.
Wait for breakout
Once prices move outside the trendline boundaries, place the trade.
Sep93
Dec
Jan 94
Figure 14.8 Flags and pennants measure rule. Use the measure rule to gauge thedecline in this stock. Take the difference between the prior minor high (point A) tothe formation low at the start (point B). Subtract the value from the high at theformation end (point C) and the result is the expected minimum price move.
providing you limit your losses. A stop placed at 44V8 or so, slightly above thefirst resistance level, works well.Take a position in the stock after a breakout, once prices move outside theformation boundary. As prices near the target price, as predicted by the measure rule, consider closing out the trade. Since the statistics regarding the success of meeting the predicted price target are so poor for these formations, beready to close out the trade sooner than expected. If you wait for prices toreach the target, you might turn a profitable trade into a losing one.
Sample TradeFor example, let us say you are considering shorting the stock shown in Figure14.8. Since the price trend is downward and it is a flag formation, the statisticssuggest that 61% of the formations will meet their price targets, on average.That is a poor showing and deserves caution.
As die chart pattern forms, you monitor the price closely by not onlycharting the end-of-day price but also checking it at midday. When you dial
into your broker for a midday price quote and discover that prices have movedoutside the bottom trendline, you decide to pull the trigger. You sell short andreceive a fill at 42, just above the closing price of 41 '/2.
226
Flags and Pennants
You follow the stock closely as prices decline. You look back through theprior year's trading history and discover two support levels at about 40 and 39.You believe, and hope, that the stock will fall through the first support level butthe second one may be more difficult. It is, after all, closer to the 38'/4 targetprice and more robust than the first level.When the stock moves sideways at the first support level, you check yourwork and reexamine the fundamentals and technical indicators. Everythingseems good so you remain in the trade.Eventually the stock pierces the first support level and declines to the second one, where it gets stuck. It closes at 39 but the next day moves up. So thefollowing day you decide to close out your position, believing that the risk of aprice rise now far exceeds the possible gain. Your short sale covers at 39 andyou receive almost $3 a share. That is not a bad profit for a hold time of just 2weeks. On an annualized basis, the return is ... wonderful!
15Flags, High and Tight
RESULTS SNAPSHOTAppearance
A consolidation region of several days to severalweeks long after a stock doubles in price
Reversal or consolidation
Short-term (up to 3 months) bullish consolidation
Failure rate
32%
Failure rate if waitedfor breakout
17%
Average rise
63%, with most likely rise between 20% and 30%;44% have gains over 50%
Volume trend
Downward
Throwbacks
47%
Having recently completed the chapter on flags and pennants, I was surprisedto discover an abundance of high, right flags. Even more surprising is their performance. The 32% failure rate is poor, but if you wait for an upside breakout,the rate drops to 17%. Reliable formations have failure rates below 20%, sohigh, tight flags score well providing you wait for the breakout.The average rise, at 63%, is among the highest I have seen for any formation. A frequency distribution suggests that die most likely rise is a moresedate 20% to 30%. However, 33% of the formations have gains over 90% and44% have gains above 50%. A 50% gain in about 2 months is a formation worthexploring!
227
228
Flags, High and Tight
Identification Guidelines
Tour
Table 15.1O'Neil Identification Characteristics of High, Tight Flags
Figure 15.1 is a classic example of a high, tight flag. The quick rise from thelow point at 14 to the flag high at 303/4 takes less than 2 months. The volumetrend is downward throughout the formation. After the slight pause, the stockcontinues rising. In another 2 months, it reaches a peak of 120.The high, tight flag is a play on momentum. When a stock doubles in ashort time, it usually takes a breather and consolidates. When it does, it givesthe trader the opportunity to buy the stock before the rise resumes. How doyou correctly identify a high, tight flag?
Identification GuidelinesThe phrase, high, tight flag is a misnomer as the formation usually does notresemble a flag formation at all. Sometimes prices move up slightly as the flagprogresses, such as shown in Figure 15.1, but more often prices spike downbriefly (a day or two) then return and move downward or horizontally beforebreaking out and heading up.The formation was popularized by William J. O'Neil in his book, How toMake Money in Stocks (McGraw-Hill, 1988). In his brief introduction to the formation, he identifies many characteristics that high, tight flags share. Table15.1 lists them.Diana Corp. (Telecom. Services, NYSE, DMA)
V
.
\ .,,,,-,-'<''"'''*''
Jan 96
Figure 15.1 A high, tight flag that sees prices rise from about 30 to 120 in 2months.
229
O'Neil Characteristic
Discussion
Substantial rise
A rise lasting less than 2 months carries prices upwardapproximately 100% to 120%.
Flag duration
Prices move sideways usually for 3 to 5 weeks.
Flag correction
During the flag phase, prices drift down a maximum of 20%.
Note: These guidelines select formations with an average gain of 69%, but only 6formations out of 81 qualify.
O'Neil's description is quite specific but it is interesting for what is doesnot say. He does not mention that prices should be moving horizontally for anextended time before the stock doubles. Some have said that this is a prerequisite, yet the charts accompanying the O'Neil text show at least one stock in asteady uptrend well before the 2-month rise to the flag begins. The chartshows a price low of about 26 while the flag forms at nearly 100.I view this extended price rise as a key. It suggests that you need only lookfor a stock that doubles in 2 months, then consolidates. By extension, youcould have a stock double, consolidate (forming a high, tight flag), then double and consolidate again, forming another higher flag. I found several stocksin the database to which this situation applies. In my selections of this formation, I made no assumptions about the prevailing trend (in other words, thechart pattern need not form from a long, flat base).Some analysts suggest volume should trend downward during the flagphase then spurt upward when prices break out of the formation. Again,O'Neil does not state this as a prerequisite and I do not consider it in my selection criteria. However, the statistics show a downward volume trend doesimprove performance.The last omission of interest is how to trade the formation. Presumably,once you spot a high, tight flag you would buy into the situation. Unfortunately, with a 32% failure rate, you may be taken to the cleaners on numerousoccasions if you follow this approach. It is safer to wait for a breakout beforetrading this and most other chart patterns.How did I select the flags in this study? I programmed my computer toidentify all stocks that have a minimum price rise of 100% in 2 months or less.Then I manually went through each stock and looked for a nearby consolidation region. If the region was close to the 100% price gain, then I accepted itas a high, tight flag. I ignored the flag duration and correction guidelines outlined in Table 15.1. The statistics later would show that these guidelines docontribute to performance but only to a minor degree.Figure 15.1 passes all the O'Neil guidelines, whereas Figure 15.2 does not(if you apply them strictly). The stock in Figure 15.2 reaches a low of 5'/4 in
230
Flags, High and Tight
Focus on Failures
Amdahl Corp. (Computers & Peripherals, ASE, AMH)
231
Table 15.2Identification Characteristics of High, Tight FlagsCharacteristic
Discussion
Substantial rise
A rise lasting less than 2 months carries prices upward at least90% (shoot for a doubling of the stock price). Stocks with 2month rises over 115% perform best.
Find consolidation
Locate a consolidation area, an area where prices pause inthe prevailing uptrend.
Receding volume trend
The volume trend in the flag should be receding for bestperformance.
Note: My guidelines result in nearly as good performance as O'Neil's but more than sixtimes the number of formations qualify.
|un94
|an95
Feb
Figure 15.2 If interpreted strictly, this high, tight flag misses all but one of theO'Neil guidelines. It sports a rise of 95% in less than 2 months (measured from thelow marked L) leading to the flag. The flag descends 22% in 38 days before breaking out and rising 33% above the highest high in early September.
early July then starts moving up. In early September, it reaches a price of 10'/4,just shy of doubling. Admittedly, the 95% price gain is less than a strict interpretation of the O'Neil guidelines, but it comes close. The high, tight flagslopes downward for 38 days, 3 more days than die maximum and declines by22%, 2% over the threshold. You could argue that the numbers are closeenough to the O'Neil guidelines to qualify as a high, tight flag. I accept it as aflag but not under the O'Neil criteria for performance testing purposes. Bynecessity, I changed the fuzzy phrases, such as approximately, into hard rules.Then I compared the performance of those flags passing his guidelines with allthe high, tight flags. A discussion of statistics appears later in this chapter.Returning to Figure 15.2, the gain from this flag registers 33%, well short ofthe average for all high, tight flags.Table 15.2 shows the guidelines that should be used in selecting and evaluating high, tight flags. First and most importantly there must be a short, quickrise. A handful (10) of the flags in the database have rises of less than 100% butnone are below 90%. Most of the stocks make the journey in less than 2months with the longest taking an extra week (67 days). Again, the key is ashort, quick doubling of the stock price.Once the stocks are selected on a price-rise basis, then look for the nearest consolidation area. Most of the time, it will be quite near. In my selections,I did not care how long die stock consolidated nor how far the flag descended
before turning upward. All that mattered was that the consolidation area wasplainly visible to the casual observer.The final identification guideline is not really for identification as muchas it is for performance. Flags widi a receding volume trend handily outperform those without. However, I would not ignore a high, tight flag simplybecause volume is rising. Rather, I would recognize that its performance maybe subpar.
Focus on FailuresInvesting in a stock showing a high, tight flag is not without risk. Figure 15.3shows a flag that suffers from what I call a 5% failure. Almost a dozen formations (17%) have upside breakouts but do not continue rising by more than5%. Since one would expect a stock to move up substantially after the breakout, I consider this behavior a failure of the stock to perform as expected.Figure 15.3 shows a quick, nearly vertical rise, leading to formation of theflag. As the rise falters, high volume tapers off. When prices head lower in theflag portion of the formation (marked in this case by two down-sloping trendlines), volume recedes. The flag drifts lower for almost a month before breaking out of the trend and heading up. After rising for just over a week to a newhigh, the stock curls around and meanders lower. It throws back to near thebase of die formation, then moves horizontally for several months before dropping lower again.If you consider the highest point in the formation as the breakout point,men this formation is a failure (because it fails to continue rising by more than5%). However, if you mark the point where prices pierce the top trendlineboundary as the breakout point, then this formation is a success. If we use suchbreakout points in this study, then all 11 of the 5% failures disappear (in otherwords, the formations are no longer failures).
232
Flags, High and Tight
Statistics
233
Medimmune Inc (Drug, NASDAQ, MEDI)
Tesoro Petroleum (Petroleum (Integrated), NYSE, TSO)Breakout Point
Jan 94
Aug
Figure 15.3 A 5% failure of a high, tight flag. Prices fail to continue moving upby more than 5% above the high reached in the flag before heading down in failure. These types of failures occur 1 7% of the time for high, tight flags.
Figure 15.4 This high, tight flag meets all the guidelines, but it fails toupward. By late March, it has given up all its gains and then some.
Sometimes, however, the flag portion of the formation is irregular andthe breakout point is not clear, so I decided to use the highest point in the formation as the breakout point. This prejudiced the performance statistics somewhat but is more conservative.Incidentally, the high, tight flag shown in Figure 15.3 obeys all theO'Neil guidelines. Unfortunately, prices rise by just 4% before tumbling.Figure 15.4 shows a blatant failure of a high, tight flag to rise. At first, thestock looks like a good candidate. From its low of 12!/2 in early October, thestock moves up and hits a high of 2 7 in early December—a double in 2 months.Then prices drift lower in the flag phase .. . and continue moving down. Eventhough it meets all the O'Neil guidelines, this stock fails to break out upwardand move higher. By late March, the stock hits a new low of 11 '/2 retracing allthe gains and a little more. The figure should emphasize how risky high, tightflags can be. Unless you wait for the upside breakout, you may be setting yourself up for a losing trade.
length should be between 3 and 5 weeks long. Others have interpreted theguideline in a similar manner.Table 15.3 shows die performance for the O'Neil selected high, tightflags with various interpretations of his definition along with my own variations. The first table entry stipulates that a flag occurs after the stock doublesand rises by no more than 120% of its base value in 2 months or less, has a flaglength from zero to 5 weeks, and a flag that declines by no more than 20%.There are 38 formations in the database that meet these criteria. Nine of themare failures but the remaining 29 show a rise averaging 47%.If you use the same guidelines and wait for an upside breakout (one thatrises above the highest high in the flag), then all the failures are eliminated and
StatisticsIt is difficult to interpret the O'Neil guidelines to assess performance. At first,I believed I read them wrong and thought the flag length was fine unless itgrew too long (over 5 weeks). Reading his guidelines again, it appears the flag
the average gain rises to 64%.
When you place a minimum limit on the flag length, your performancerises to 69%, but you only have six formations that qualify. I do not view thisas a positive step since this formation is scarce enough without making it lesslikely to occur. If you remove the minimum flag length and substitute a receding volume trend, then the average gain becomes 68% with 20 formationsreporting in and no failures.Scrapping many of the selection guidelines except for a minimum 90%rise in 2 months or less, a receding volume trend, and an upside breakout, Ifound the average gain to be 65% with 40 formations qualifying. Then Ichanged the minimum price rise in 5% intervals. The performance dips at
234
Flags, High and Tight
Statistics
Table 15.3Performance Statistics under Various Selection CriteriaO'Neil Criteria
Cain (%)
Failures/Formations
100-120% rise, up to 5-week flag,maximum 20% flag decline
47
9/38 or 24%
100-120% rise, up to 5-week flag,maximum 20% flag decline, waitfor breakout
64
0/29
100-120% rise, up to 3-5 week flag,maximum 20% flag decline, waitfor breakout
69
0/6
100-120% rise, up to 5-week flag,maximum 20% flag decline, waitfor breakout, receding volume
68
0/20
My Criteria
Gain (%)
Failures/Formations
Minimum 90% rise, recedingvolume, wait for breakout
65
0/40
Minimum 95% rise, recedingvolume, wait for breakout
63
0/36
Minimum 100% rise, recedingvolume, wait for breakout
63
0/35
Minimum 105% rise, recedingvolume, wait for breakout
75
0/29
Minimum 1 10% rise, recedingvolume, wait for breakout
84
0/24
Minimum 115% rise, recedingvolume, wait for breakout
93
0/15
95% and 100% but then rises steadily to an average gain of 93% at the 115%interval. The performance deteriorates beyond this point.You can see in Table 15.3 that the number of qualifying formations alsodrops from 40 to 15. Of course, you must recognize that the selection criteriais simply tuning the performance of the database. As such, your results willvary.If I can locate more high, tight flags by using fewer guidelines and notsuffer any meaningful performance degradation, then why not do so? Putanother way, I removed each selection criterion from the stocks that passed theO'Neil guidelines and found their influence to be positive but less than 4%.For example, when I removed the stipulation that a flag must have a maximum20% correction, the performance drops from 64% to 63%. The guideline addsvalue, but it limits the number of stocks qualifying without significandy boosting performance.
235
The only guideline diat improves performance when it is removed is the100% to 120% price rise stipulation. The best range turns out to be between110% and 140% for the stocks in this database.What do all these statistics mean? I view an average price rise of 65% with40 formations qualifying as better than a 69% rise with only 6 formations making the grade (because you have more opportunities to make a killing). The statistics in Tables 15.4 and 15.5 refer to my guidelines outlined in Table 15.2,not to the O'Neil criteria.Table 15.4 shows the general statistics for high, tight flags that follow myguidelines oudined in Table 15.2. I located 81 formations in 2,500 years ofdaily price data—a rare formation indeed.Most of them (78%) are consolidations of the prevailing trend. Theremainder are reversals and every reversal is also a failure.The failure rate at 32% is quite high. However, when you wait for anupside breakout, the failure rate drops to 17%. I view failure rates below 20%to be reliable, so you really should wait for an upside breakout before taking aposition in a stock.The average rise is an exceedingly high 63 %. This value does not includethe idea that the flag should show receding volume as a selection guideline toimprove performance. If you include such a guideline, then your performancerises to 65%, as measured from the highest high in the flag (or die highest highleading to it). This penalizes performance since you could compute the resultsusing the breakout low instead of die flag high. Doing so reduces the numberof 5% failures from 11 to zero while boosting the average gain. You would stillhave four regular failures, so even this method is not perfect.Figure 15.5 is a graph showing the frequency distribution of gains. If youignore the right-most column for a moment, then the columns with the highTable 15.4General Statistics for High, Tight FlagsDescription
Statistic
Number of formations in 500 stocks fromReversal or consolidation
8163 consolidations, 18 reversals
Failure rate
26 or 32%
1991 to 1996
Failure rate if waited for upside breakout
11 or 1 7%
Average rise of successful formationsMost likely rise
63%20% to 30%
Average formation length
20 days
Average volume trend
60 or 74% down
Note: These general statistics follow the guidelines in Table 15.2 with the exception of adownward volume trend.
236
Flags, High and Tight
Table 1Breakout Statistics For
33%
DescriptionUpside breakoutDownside breakoutUpside breakout but failure (5% failures)
ThrowbacksAverage time to throwback completionFor successful formations, days to ultimate high
Percentage of breakouts occurring near 12-monlow (L), center (C), or high (H)Percentage gain for each 12-month lookback pe
40
50
60
Percentage Gain
Figure 15.5 Frequenty distribution of gains for high, tight flags. The gains over90% skew the overall average upward.
est frequencies are 20% and 30%. I consider these two ranges the gain aninvestor is likely to make. However, since 33% of the formations have gainsover 90%, the most likely gain may be higher.The average formation length is 20 days, suggesting that many of the formations do not meet the O'Neil guidelines of 3 to 5 weeks for flag length.Many of the formations (74%) have receding volume trends. Six out of 21failures (or 29%) have volume trends that are rising. About half (53%) of thesuccessful formations having rising volume trends also show below averagepercentage gains. These statistics further support the notion that a recedingvolume trend is beneficial.Table 15.5 shows breakout statistics for those formations obeying myguidelines. Most of the formations (81%) have upside breakouts and only 17%of these fail to continue moving higher than 5%.The percentage of throwbacks, at 47% of formations with upside breakouts, is not high enough to formulate any sort of trading policy. If you discovera high, tight flag that is throwing back to the formation, then wait for thethrowback to complete. The throwback must reverse and prices must move upbefore you buy in, otherwise the trend may not reverse and you will end upwith a loss. The time to throwback completion is 11 days, about average withother formations in this book.The number of days to reach the ultimate high is a very short 2 months(70 days). This follows the quick 2-month price rise that initiated the trend.After the stock consolidates from a few days to several weeks, the upward trend
resumes. Thus, the high, tight flag behava half-mast formation (at least in termmonths after the formation).Most of the formations (92%) occuyearly price range into thirds and distribthose formations in the highest third ofgains averaging 70%. The poor showingcenter third of the yearly price range offemations in the lowest third, as you would
Trading Tactics
Table 15.6 outlines trading tactics for hirule for high, tight flags. However, almo24%) have gains after the breakout thattion. In other words, the high, tight flagrise.There is really only one trading tacshows an example of this tactic. Take a p
Table 1Trading Tactics for HTrading Tactic
Measure ruleBuy after breakout
Explanation
None. The formation cabenchmark but be con
If prices break out of tnot tell if a breakout hathe highest high in the
238
Flags, High and Tight
Sample Trade
Figure 15.6 A high, tight flag with prices stair-stepping higher. How do youtrade this high, tight flag? Buy into the situation once prices rise above the breakout level. You may buy sooner, once prices stage a breakout by piercing the toptrendline, but you increase your risk of failure.
of the flag formation. This breakout is not always clear. In Figure 15.6, if youlook closely, the stock appears to break through the top trendline 3 days beforethe actual breakout. In many cases, you cannot draw a straight trendlinethroughout the flag formation, making it difficult to gauge when a breakoutoccurs. For this reason, I use the top of the formation as the breakout point(shown in Figure 15.6 as the breakout level). If you are skeptical of this guid