Flagging Into Support

05/25/05 08:29:59 AM

by David Penn

A bullish flag that ends where moving average support begins can be a prelude to profits.

Security: PLMO
Position: N/A

One of the first things I remember someone telling me about chart patterns and trading was that, as fun as chart patterns were, "You can't trade them."

At the time, my experience was such that I would have believed that a head and shoulders bottom got its name from a loss-crazed, short-selling technical analyst who dismembered his broker. ("I'll show you a head and shoulders pattern!!!") So I've carried that notion along ever since, recognizing chart patterns in any number of markets with a guilty sense that I was just this side of wasting time--as far as actually trading those markets was concerned.

Figure 1: PLMO. Following a bullish positive divergence in late April that propelled shares of Palm One higher, a bullish flag that found support on the 10- and 50-day EMAs sets the stage for the next leg higher.

Graphic provided by: Prophet Financial, Inc.

But was that notion right? From a certain perspective, anything that makes you money legitimately and with (relative) consistency is worthwhile, whether that "thing" is an indicator, a chart pattern, a reading of the tape, or even a study of the stars. And from still yet another perspective, that notion--however right it may be--is undermined when chart patterns and technical indicators are combined. In fact, in the right context and in the right combinations, that notion of the ineffectiveness of chart patterns for real world trading turns out to be little more than an urban legend alive and well in the world of technical analysis.

The case of PLMO--Palm One--is instructive. Shares of Palm One had been in a dedicated downtrend since topping in December 2004. This downtrend came to a halt in the first few months of 2005, as PLMO slipped into a sideways consolidation range from mid-February through April. Toward the end of that consolidation, Palm One gave its first signs that it might be able to move higher with a positive stochastic divergence near the end of April (actually, there was a positive stochastic divergence in mid-April but, based on my personal entry rules, there would have been no opportunity--fortunately--to get long). See Figure 1.

The bounce from the month-long positive stochastic divergence moved shares of Palm One from under 22 to an intraday high above 26 in under eight days. At this point, the market for PLMO gave a great warning of a pullback on May 10 in the form of a shooting star Japanese candlestick on increased volume. This candlestick anticipated a down-to-sideways correction over the following four to five days that took the form of a bullish flag.

Now, a bullish flag is a consolidation in an uptrend. The consolidation is short term--lasting only a few days--and its price action is bound by a pair of parallel lines (if the lines binding the short-term consolidation converge, then the pattern is referred to as a bullish pennant). A breakout from the bullish flag occurs when prices penetrate the upper boundary of the pattern, preferably on increasing volume.

Increased volume did not accompany the breakout from the bullish flag shown here. But increased volume was in evidence in the days that followed, with the two days following the breakout day sporting volumes that were more than three times that of the breakout day itself. What was also key was the appearance of potentially tremendous support in the form of the upwardly trending 10- and 50-day exponential moving averages (EMA).

The measurement rule for flags seems to make for ambitious upside price targets. Nevertheless, PLMO appears primed to perform. To arrive at a minimum upside price objective, measure the distance from the beginning of the advance to the beginning of the flag pattern, and then add that amount to the value at the bottom of the flag pattern. In the case of Palm One, a distance of about 5 is added to a value between 24 and 25 (depending on how you deal with long tails on candlesticks) to arrive at an upside minimum between 29 and 30.

With a closing price on May 24 of 28.84, shares of Palm One seem right on track.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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