Pennant Trading Strategy – What Is It? (Backtest)
Last Updated on November 9, 2022
Chart patterns are one of the most powerful for analyzing price action. They help you to understand the rice structure and the state of the trend. Pennants are one of the common chart patterns traders look out for, but what is a pennant trading strategy?
In price chart analysis, a pennant is a continuation chart pattern that forms when the market consolidates after a rapid price move. The pattern can be seen in any time frame, and it consists of a small triangular price formation that follows a fast price movement in either an uptrend or a downtrend.
In this post, we take a look at pennants and how to trade them. At the end of the article, we make a backtest of the trading strategy.
What is a pennant in trading?
In price chart analysis of the financial markets, a pennant is a continuation chart pattern that forms when the market consolidates after a sharp move. The pattern can be seen in any time frame, and it consists of a small triangular price formation that follows a fast price movement, which can be seen in an uptrend or a downtrend.
The pennant is a relatively short chart formation and appears as a small triangle pattern that forms after a steep trend. It is named the pennant pattern because it resembles a pennant on a flagpole. The chart pattern is characterized by a countertrend price consolidation (the pennant) that follows a rapid price ascent or descent (the pole). The triangle that forms the pennant could be a symmetrical, ascending, or descending triangle.
It is considered a continuation pattern, as it signifies the market taking a breather before resuming its movement. Although it is less popular than the flag pattern, a similar pattern with a rectangular consolidation pattern as against the triangular pattern in the pennant, traders consider the pennant pattern to be extremely reliable. They use it to identify the possible continuation of a previous trend.
For the pennant pattern to be complete and potentially present a trade signal, the price must break out of the triangular consolidation. If the breakout happens on the side of the preceding trend, it gives a trade signal, but if the breakout happens on the opposite side, the pattern has failed.
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Backtested trading strategies
Another factor to consider is the volume. The breakout to the side of the trend must be accompanied by a huge volume. Usually, when the trend resumes, the price movement tends to be rapid, just like the one that precedes the flag formation. So, it is important to notice the flag pattern in time and position to take advantage of it.
How to identify a pennant chart formation
The pennant structure is a small triangle formation that represents an area of tight consolidation in price action. It can form in an upward trend and a downward trend and usually follows a rapid price move. Here are the things to look out for to identify a pennant formation:
- The pole: This is a rapid price swing in the direction of the preceding trend.
- The pennant structure: This is a small consolidation triangle that follows the rapid price move. It typically consists of between five and fifteen price bars.
- A breakout/breakdown: This is the price closing above the upper border of the triangle formation in the case of a pennant pattern in an uptrend or below the lower border of the triangle formation in the case of a pennant pattern in a downtrend. The breakout/breakdown is a confirmation that the price is about to continue moving in the direction of the trend.
- The ratio of the pole to pennant: The bottom of the flag should not exceed the midpoint of the pole that preceded it.
- The shape of the pattern: The price consolidation is often within a small triangle with a converging right end. If the lines are parallel, giving the consolidation a rectangular structure, the formation becomes a flag pattern.
Both the pennant and flag patterns are among the most reliable continuation patterns used by price action traders, and they tend to form in similar situations in an existing trend.
Is a pennant bullish or bearish?
The pennant chart pattern can be bullish or bearish, depending on the trend it forms in and the pole-pennant configuration. A bullish pennant forms in an uptrend, and as such, has an upward pole, which is formed by a rapid price ascent, with the pennant price consolidation hanging at the upper end of the pole.
The bullish pennant signifies a pause in the price movement in an uptrend; the price is expected to continue rising when it breaks above the upper border of the pennant. So, it is regarded as a bullish continuation pattern.
A bearish pennant is seen in a downtrend, and as a result, it has an upward pole, which is formed by a rapid price decline, with the pennant price consolidation hanging at the lower end of the pole. The bearish pennant signifies a pause in the price movement in a downtrend; the price is expected to continue declining when it breaks below the lower border of the pennant, which is why it is regarded as a bearish continuation pattern.
How do you trade a pennant?
You can add the pennant pattern to your price action trading arsenals. If you learn how to trade the pattern, you can use it to establish your trade entry, stop loss level, and profit target (why not use profit targets). Here is a brief guide on how you can trade the two types of the pennant pattern:
How to trade a bullish pennant pattern
The key things to take note of when using the bullish pennant pattern are when to buy, where to place your stop loss, and where to take profit:
- The buy signal: A buy signal is generated when the price breaks above the upper border of the pennant pattern. The breakout is valid only after the price has closed above that upper boundary, so if you are trading on the daily timeframe, you may go long at the open of the next trading day. While some traders place buy limit orders in anticipation of a breakout, there can be false breakouts. To avoid a false signal, it is wise to wait for the price to break above the upper boundary of consolidation.
- The stop loss level: Usually, the lower boundary of the pennant formation is used as a reference point for the stop loss order. You can place your stop loss some distance below that lower boundary of the pennant when the breakout happened. For instance, if you are trading a stock, place your stop loss some cents or dollars below the price level that marked the lower boundary of the pattern.
- The profit target: Usually, the price is expected to make a similar move to the one that preceded the pennant pattern consolidation. So, to get your profit target, you measure the size of that preceding upswing (the pole) and project it from the lower boundary of the pennant at the point of the breakout. If you want to take a quick profit or make use of two profit targets, a more conservative profit target would be to use the size of the base of the consolidation triangle (the pennant).
How to trade a bearish pennant
Here are the key things to note when trading the bearish pennant pattern:
- The sell signal: A sell signal is generated when the price breaks below the lower border of the pennant pattern. The breakout is valid only after the price has closed below that boundary, so you should enter your trade on the open of the next candlestick. While some traders do place sell limit orders in anticipation of a breakout, there can be false breakouts. The best thing is to wait to confirm a breakout and then enter a trade with a market order.
- The stop loss level: You can place your stop loss some distance above the upper boundary of the pennant. For instance, if you are trading a stock, place your stop loss some cents or dollars above the price level that marked the upper boundary of the pattern.
- The profit target: Since the price is expected to make a similar move to the one that preceded the pennant consolidation, to get your profit target, you measure the size of that preceding upswing (the pole) and project it downward from the upper boundary of the pennant at the point of the breakout. For a quick profit, a more conservative profit target would be to use the size of the base of the consolidation triangle (the pennant).
Pennant trading example
PENN Entertainment, Inc (Nasdaq: PENN) was one of the hardest-hit stocks during the Covid-19 pandemic market selloff. However, following swift government intervention and the fast market recovery that followed, the stock rose rapidly during the months of April, May, and June 2020. It then formed a bullish pennant in June and the early part of July. When the price broke above the pennant on July 15, what followed was a swift price rally during the months of August and September.
If you had bought at the breakout at $34 per share, you could have sold for $67 per share in September, nearly a 100% profit in just two months, without the use of any leverage.
Pennant trading strategy backtest
It’s pretty demanding to make a pennant trading strategy with strict trading rules and settings because of all the rules required. Thus, we don’t think it’s worth the time to look into.
Instead, 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.
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.
Let’s start with the results for pennants:
|#Formations among 500 stocks from 1991 to 1996||144||106|
|Reversal or consolidation||130 consolidations|
|#Failure rate in uptrend||10 (13%)||12 (19%)|
|Failure rate in downtrend||8 (12%)||15 (34%)|
|Throwbacks||7 (10%)||8 (16%)|
|Pullbacks||12 (20%)||5 (17%)|
|The average length of the formation||11 days||10 days|
|Downward volume trend||112 (78%)||95 (90%)|
|Avg rise in uptrend||19%||21%|
|Avg decline in downtrend||17%||17%|
|Percentage meeting target in uptrend||63%||58%|
|Percentage meeting target in downtrend||61%||52%|
According to Bulkowski, the percentage of formations that meet or exceed their predicted price targets is disappointing for both flags and pennants. He views values above 80% to be reliable, and 52 and 63% is not going to cut it.
Pennant Trading Strategy – closing remarks
We were not able to develop a 100% quantified pennant pattern trading strategy.
However, Thomas Bulkowski’s statistics and metrics from his best-selling book shed some light on the probabilities (and difficulties) of making money on flags and pennants. 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 trading rules. There is a reason why the name of the website is Quantified Strategies! You can have a look at our good and profitable trading strategies, or you can find our absolute best strategies behind a paywall: