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As I mentioned in a recent Charts in Play, flag formations are one of my favorite chart patterns to trade. These triangles generally represent continuation patterns or pauses in a major trend.

Therefore, when you are looking to trade or invest based on flag patterns, you have already made a decision about the direction of the major trend.

When a flag is formed as an interruption in the major uptrend, it is often referred to as a "bull flag." The formation of a flag during a downtrend is, therefore, known as a "bear flag."

In addition to simplifying the major trend analysis, one can also use Fibonacci analysis on the flag formation to give you an objective entry-level protective stop, as well as an initial profit target. This allows you to clearly assess the risk and reward of each trade.

The flags can take a wide range of shapes, as some are quite simple and others are quite complex. Often in a major trend, you will see a number of flag formations that can occur over a several years within a major up- or downtrend.

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During the 2007-2009 bear market, there were quite a few "bear flags" evident on the daily chart of the Spyder Trust (SPY).

In 2008, there was a classic bear-market rally from the March 2008 lows that ended in May. The SPY had topped out on October 10, 2007 at $157.52 (point 1), and the first wave of selling took SPY to a low of $140.66 in late November.

The ensuing rebound was quite sharp—this is typical in bear markets—as SPY gained 8.9% in just 11 days before the decline resumed. The next wave of selling was much more severe; the SPY dropped from $152.89 to a low of $126 (point 2) in late January 2008.

The 17% decline pushed sentiment to extremes. By February, most newsletter writers were convinced that a new bear market was underway. The SPY retested the January lows in March (point 3), setting the stage for a bear-market rally.

Flags are often formed in reaction to extremes in sentiment. By the time the bear flag was completed in May, many of the February bears had turned bullish on the market.

By the middle of April, SPY had formed an upward trading channel (lines b and c). With the peak in May, a more pronounced flag formation was evident. The Fibonacci retracement resistance levels calculated from the October high (point 1) and the January low (point 3) allowed one to define the levels where the rally could be expected to fail.

The 38.2% retracement resistance at $137.60 was tested in April, but SPY was unable to close above it. Two weeks later, SPY did close higher, setting the stage for a rally to the 50% retracement resistance at $141.22. (For more, see Fibonacci Analysis: Master the Basics.)

Typically, bear-market rallies will fail near or slightly above the 50% retracement resistance. If the 61.8% retracement resistance at $144.81 was exceeded on a closing basis, it would suggest that one’s analysis of the major trend is wrong.

Once the 50% retracement resistance level was first reached on May 2, the focus was clearly on the short side as a broader flag formation (lines a and c) was then evident.

Now, there are two main ways to trade these flag formations. One is to identify a selling zone, using a stop above the 61.8% resistance levels. Or, alternatively, one can wait until the flag formation is completed.

The first setback from the test of the 50% retracement resistance lasted five days and held the uptrend (line c). As SPY again turned higher, the target selling zone was either the prior high at $142.37 or the midpoint between the two resistance levels, which was $143.01.

In determining your selling level, one must of course compare it to your stop level, the potential profit target, and then decide the amount of risk you are willing to accept. Selling at the prior high of $142.37 would have made it quite likely that your trade would be filled—or, alternatively, you could sell closer to the halfway point between the two retracement levels.

Since markets often stop at round numbers a bit under $143.01, a point like $142.88 would have made sense. SPY formed a doji on May 19, 2008, as it made a high at $144.30.