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FLAGS AND PENNANTS


December Cotton's Flag

11/22/00 03:33:07 PM
by David Penn

December cotton peaked in late August at about 67 cents, and then formed a flag between 66 and 64 in November. The initial breakout was bearish. Will the bulls respond?

Security:   CTZ0
Position:   N/A

A flag, which is characterized by a short-lived, sloping rectangle bordered by two parallel trendlines, usually represents the midway point in a significant price move. As such, a flag in December cotton might have made more sense in late July or early August--when cotton rose from less than 57 cents to about 67 cents--than in November, when cotton seemed caught between its August highs and fairly sturdy support at 62 cents. But many of the flag pattern's trademarks are present and accounted for here: the sloping rectangle, the aggressive price move, the declining volume trend during the formation . . . So much so that looking at December cotton through the lens of the flag formation might provide further hints as to where December cotton may be headed next.

First, look at the flag. The pattern developing in December cotton in November consists initially of four bullish trading sessions that took prices from about 62.5 cents to just under 66 cents. This assertive price movement might be considered a minimum precursor to the flag formation. More sessions of bullish trading as well as a greater price range from the first movement to the initial development of the flag might have made for a more convincing (though not necessarily more accurate) build-up. However, the basic ingredients of a flag are in place by early November.

Successful flag formations tend to develop against the trend and breakout with the trend. Here, the initial breakout is against the trend. Note also how on-balance volume descends all the more sharply during the flag.
Graphic provided by: MetaStock.
Graphic provided by: TradeSignals.com.
 
The flag itself is bounded by two sloping trendlines such that the resulting pattern resembles an open-ended rectangle. During the development of the flag pattern, volume typically trails off. This action is shown here by the on-balance volume (OBV) chart, which shows a gradually lower volume trend over the summer months. But the sharpest declines are in November, as the flag formation is completed and a downside breakout occurs.

The breakout from flag formations tends to follow the trend--particularly insofar as the flag tends to develop against the trend. Here, with December cotton, the issue of "the trend" is a little trickier. While there is a short-term downward trend that moves from the August highs to December cotton's current prices, a more compelling upward trend exists--drawn from the July low through the lows of October. This is the trend against which the flag developed. Still, establishing an upward trend from July to November means reconciling what "should" be an upside breakout (upward trend, downward flag, upward breakout) in December cotton. However, the breakout was also downward, taking prices down to about 63 cents. So is December cotton, at this point, a long or a short?

The 62 cent level should help provide an answer to this question. December cotton has found significant support at 62 cents in September and October, where a number of declines were halted. Should December cotton plunge beneath the 62 cent level, then it would be clear that a flag failure had occurred and that further declines might be coming. In fact, even if prices rally they would need to rise to at least 66 cents just to reach the top of the flag. Given the declines in on-balance volume, such an advance at this point may seem like a tall order. But December cotton closed regularly above 66 cents between mid-August and mid-September. Bulls willing, cotton may rise again.



David Penn

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

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