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The historic bear market that followed the top in the Japanese Nikkei-225 has lasted a couple of decades, and has included many bear flag formations.

I included it to demonstrate how they form in all markets, over any time periods. (I have some chart books from the 1970s and earlier that have great examples of flag formations. In the original Edwards and Magee, there are countless examples from the 1930s and 1940s.)

From the December 1989 high of 38,957, the Nikkei finally bottomed in April 1990 with a low of 27,251. After a 10,000-point slide, the rebound was quite sharp, and the 38.2% resistance level at 31,722 was exceeded by early May.

The Nikkei traded above the 50% retracement resistance at 33,104 several times over a two-week span in late May and early June. The 61.8% resistance was at 34,485.

The short-term support (line b) was finally broken, as the Nikkei declined to test the 38.2% support (line 4). The following rally allowed one to define a longer-term flag formation (lines a and c). The three-week rally took the Nikkei back to the 50% retracement resistance.

How might you have traded this? Of course, the impetus for most was looking for a spot to get out of longs.

For those who were looking to short, selling at the 50% retracement resistance with a stop 0.5% above the 61.8% resistance level was a reasonable strategy after a 10,000-point decline. (Occasionally you will see a flag that exceeds the 61.8% resistance, but it will not exceed the 78.6% resistance before it is completed.)

Thus, a sell at 33,104 with a stop at (34,485 + (34,485*.005) = 34,658 would have had a risk of 1,554 points. If the Nikkei just tested the lows, the potential reward would have been 33,104 - 27,551 = 5,853 points, for a risk-reward of 3.76:1. The 127.2% target was at 25,658, which made the risk-reward look considerably better.

Of course, one could have waited for the flag formation to be completed, once support (line c) was broken on July 23, 1990. The Nikkei opened the following day at 31,834, so a stop 0.5% above the prior high of 33,186 (33,352) would be standard. This would have been a risk of 1,518 points, with a minimum potential reward of 5,853. Both the 127.2% and the 161.8% targets were met in late August.

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