I Pledge Allegiance

When I was growing up every morning in school, actually before class started we were required to stand up, pledge allegiance and give respect to the US flag. I think schools have since moved away from this practice for whatever reason.  In technical analysis flags are patterns we have similarly high esteem for.  Flags are usually continuation patterns that occur after price has moved up strongly over a short period of time (creating a “pole”) and then takes a breather by consolidating (creating the flag) either sideways or down.

The reason they are revered from a technical analysis standpoint is:

1.       Once the consolidation is over there is a high probability they continue in the direction of the trend prior to the consolidation.

2.       Their price objective from the breakout of the pattern is easily identified allowing you to have a more accurate assessment of your risk / reward ratio before you invest.  The upside target is calculated by adding the length of the pole to the breakout price.  The longer the pole, the more attractive the opportunity.

3.       Because there are no guarantees, if you are wrong and price reverses course after a breakout,  a stop order can be placed back inside the consolidation zone, allowing you to exit the investment with a very small loss (remember the key to long term success is keeping losses small and letting your winners run)

4.       These patterns are easy to manage as you can just place a buy stop above the breakout high not having to commit or risk investment capital until the breakout occurs.

Below are a couple of examples I have been stalking, waiting patiently to potentially enter.

The first is Costco (COST) a stock which I wrote about in July of last year when I warned it was ready to breakout at $118/share. It did that and has run up nicely to near $150, a nice 27% gain thus outperforming the SP500 which has risen less than 6% during that same time period.  As you can see in the chart below, price moved up quickly from ~135 to ~$150 where it has been consolidating sideways over the past month creating a bull flag pattern.  If/when this eventually breaks out to the upside the target will be ~$165.

The second opportunity we are stalking is Linkedin (LNKD) which has a better upside target of about $55.  It, too, has been consolidating for about a month preparing for its next move.

One thing that is common in these types of opportunities that needs to be mentioned is during their initial quick moves up which create the “pole”, most often they will also create an overbought condition on their momentum indicators. It’s hard for price to move higher without relieving this condition, which is why it consolidates allowing the bulls a breather in order to prepare for the next move up.  In both charts you can see (in the upper pane) RSI becomes initially overbought and then as price moves sideways, the overbought condition moves back into the normal bullish range. What makes these two examples unusually compelling is the fact price is moving sideways during the consolidation period. As we know consolidations can be either sideways or down and sideways is reflective of strength and the potential for a bigger move up, if/once it begins.