Bear Flag Chart Pattern Strategy — What Is It? (Backtest And Example)
Last Updated on April 18, 2023
Spotting trends at the early stages can be a challenging task, but at least, you can trade the continuation if you know what to look for. Bull and bear flags are popular trend continuation patterns in technical analysis, but here, we will focus on the bear flag. What is the bear flag chart pattern strategy?
A bear flag is a small price consolidation pattern that forms after a rapid price move in a downtrend. It is a small downward sloping price channel that can be delineated with two parallel lines hanging off a rapid price decline that forms the pole of the flag. It is a bearish continuation pattern, meaning that the price is likely to continue the preceding downtrend.
Let’s take a look at this chart pattern. At the end of the article, we make a bear flag pattern strategy backtest.
What is a bear flag chart pattern?
A bear flag is a bearish continuation chart pattern that forms after a rapid price drop. It is a small price consolidation pattern that forms after a rapid price move in a downtrend. The flag is a small up-sloping price channel that can be delineated with two parallel lines hanging off a rapid price decline that forms the pole of the flag.
The pattern represents an area of tight consolidation in price action showing a countertrend move that follows directly after a sharp price drop. A bear flag pattern has these main characteristics:
- The preceding trend: There is an existing downtrend. Before the bear flag consolidation pattern, the price usually experiences a rapid decline — this forms the flag pole.
- The consolidation channel: The pattern typically consists of between five and twenty price bars within a tight channel, which can be an up-sloping or horizontal channel. The top of this channel should be below the midpoint of the flag pole. If the price consolidation is triangular, the pattern is called a bear pennant, instead of a bear flag.
- The volume pattern: The consolidation channel forms on volume decline but there’s a sharp volume increase on the downward breakout.
- A breakout: The price breaks to the downside. A breakout to the upside invalidates the pattern.
An example of a bear flag pattern is below in SPY (S&P 500) during the financial crisis in 2008/09:
Being a bearish continuation pattern, the price is likely to continue the preceding downtrend. This is why the bear flag pattern is used to identify the possible continuation of a bearish market. When the downtrend resumes, the next price drop could be rapid, making the timing of a trade advantageous by noticing the bear flag pattern.
A bear flag is sometimes called a pennant. In this article, we treat them as equals.
What does a bear flag signify?
A bear flag signifies a pause in price movement after a rapid price decline. It is a sign of profit taking on the side of short sellers and early buying on the side of buyers who were apparently expecting an exhaustion move to buy into the market. Looking at the illustration, you would notice that the pattern is formed from the flag pole, which is a steep downward move before the pullback, and the flag itself represents the actual retracement.
The flag pole represents an almost panic price drop in the market as though some previous holders just capitulated. Then, it is followed by a small dead cat bounce that forms the flag. What happened is that the initial sell-off comes to an end through some profit-taking.
Meanwhile, some traders are also entering long positions looking for a reversal, and this forces the price to drift in an upwards direction and form a tight range making slightly higher lows and higher highs. But there is still selling pressure, as shown by the subsequent breakout to the downside.
A breakout below the lower trendline triggers panic sellers as the downtrend resumes another leg down. As a trader, during the consolidation, you should be prepared to take action should the price break down through the lower boundary of the channel because what would follow is another rapid decline since bears are in control again to force another sell-off.
The success of a bear flag can be greater after a significant downside move due to the possible increase of overhead resistance. Furthermore, when the swing low that begins the pattern is also an all-time low, the price drop is also very huge due to the possible lack of underlying support.
What does a bear flag look like in trading?
As we have already pointed out, a bear flag has a downward pole formed by a rapid price decline, and the flag, which is a tight price channel. The parallel lines that form the boundaries of the bear flag can slope upward or stay horizontal. The setup completes when the price breaks below the lower boundary to continue with the downtrend.
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Backtested trading strategies
So, identifying a bear flag is quite easy if you understand the components. Here are the things you need to look out for:
- Spot the flag pole formed by a significant price decline. This decline can be steep or slowly sloping and will establish the basis for the downtrend.
- Look for the bear flag itself, which is a period of consolidation after the initial price decline. You may notice that the price slowly channels upward and retrace a portion of the initial move. This retracement should never be more than half of the initial price decline.
- Wait for the price to break below the lower boundary of the flag. This breakout is what completes the bear flag trade setup. At this point, you can enter a short-selling position. The profit target is a potential value to take profit after the next decline in price. You identify the profit target by first measuring the distance of the initial decline. This value can then be subtracted from the upper line of the consolidation flag.
How do you trade a bear flag pattern?
You trade a bear flag in the downward direction — which means, you open a short position when the pattern is completed.
But how do you know when to open a position, the type of order to use, your stop loss, and profit target? Here are the steps to follow:
- Identify the pattern: Look for a steep price decline (the flag pole) that is followed by a period of price consolidation (the flag). The flag may be a horizontal range or slightly displaced upward.
- Mark the upper and lower boundaries of the flag: Use trendlines to mark the upper and lower boundaries of the channel that forms the flag.
- Wait for a downward breakout below the flag: The price would bounce up and down within the channel until it breaks out of the channel. The breakout can be to the downside or the upside, which invalidates the pattern unless the price doesn’t progress but instead enters back into the channel — in this case, the upside breakout becomes a fakey. You watch out for a downward breakout.
- Check the breakout volume: When a downside breakout happens, check the trading volume of the breakout price bar. You want to see the breakout happen with a huge trading volume.
- Enter a short position: If everything checks out, enter a short position. You can place a market sell order or a sell stop order. A sell limit order may not work because the price drop that follows a breakout is usually rapid, and the price rarely goes back to retest the breakout level, the limit order may not be triggered. However, keep in mind that short selling is difficult. Why is short selling difficult?
- Place your stop loss and profit target: You can place your stop loss above the highest level of the flag. For your profit target, you first measure the distance of the initial decline and then subtract the value from the upper line of the flag where the latest decline started.
Here is a bear flag in the AUDUSD chart, showing potential trade entry, stop loss, and profit target. Note how the profit target is measured.
Can a bear flag be bullish?
No, as the name implies, a bear flag is a bearish continuation chart pattern and indicates a potential price decline once the price breaks out below the lower end of the flag consolidation.
Nonetheless, the price can still break out above the upper end of the flag consolidation channel and trigger the reversal of the trend. In fact, it is even possible for this upside breakout from the channel to occur after a false breakout to the downside. But this does not make the bear flag bullish; rather, when this happens, it means that the bear flag pattern has been invalidated.
Bear flag vs. bull flag
Bear flags and bull flags are similar in many ways: they are both continuation patterns and have similar structures (the flag pole and the flag). However, they are mirror images of themselves and form in different trends.
The bear flag forms in a downtrend, where you would see a price decline followed by consolidation and then the breakout to continue the downtrend. So, it is a bearish continuation pattern.
The bull flag, on the other hand, forms in an uptrend, where you would see a price rise followed by consolidation and then the breakout to continue the uptrend. Thus, the bull flag is a bullish continuation pattern.
Bear flag chart pattern trading strategy (backtest and example)
It’s pretty demanding to make a bear flag pattern trading strategy with strict trading rules and settings because of all the rules required. It’s possible, of course, but we believe some already published stuff is good enough.
Instead of a quantified backtest with defined trading rules, we rely on data from Thomas Bulkowski’s book from the late 90s called The Encyclopedia of Chart Patterns. His book is not based on strict quantified rules or data driven backtests, but rather on visual confirmation. Nevertheless, we believe his findings are a decent approximation of the usefulness of the bear flags (and pennants).
Bulkowski, an engineer, sat down and went through technical formations for 500 stocks over a period of five years. This gave a total database of 2 500 years, although of course there are sources of error as all the stocks are from the same time period. In total, he registered over 15 000 technical formations, of which he divided rectangles into two groups: Rectangle bottoms and rectangle tops.
In the table below we are summarizing all info for flags and pennants from Bulkowski’s book. Keep in mind that these are general statistics for flags and pennants, not only a bear flag.
|#Formations among 500 stocks from 1991 to 1996||144||106|
|Reversal or consolidation||130 consolidations|
|The failure rate in an uptrend||10 (13%)||12 (19%)|
|The failure rate in a downtrend||8 (12%)||15 (34%)|
Statistics for flags and pennants when the price trend is rising:
|Price trend duration||62 days||53 days|
|Avg rise leading to the formation||19%||22%|
|Avg rise after formation||19%||21%|
|Most likely rise after formation||20%||15 to 20%|
|Of those succeeding, the # meeting or exceeding price target||63%||58%|
Statistics for flags and pennants when the price trend is declining:
|Price trend duration||50 days||52 days|
|Avg decline leading to the formation||18%||17%|
|Avg decline after formation||17%||17%|
|Most likely decline after formation||15%||25%|
|Of those succeeding, the # meeting or exceeding price target||61%||52%|
Bear flag pattern trading Strategy – conclusion
Although we were not able to make a strict backtest with trading rules, we took good use of the research by Thomas Bulkowski.
Nevertheless, we recommend being cautious due to the lack of 100% quantified trading rules. Bulkowski’s research is based on after the fact analysis. As a matter of fact, you should be cautious about any technical analysis that is not based on 100% verifiable rules. There is a reason why the name of the website is Quantified Strategies! If you are looking for a robust and profitable trading strategy, you can find our absolute best strategies behind a paywall: