Amazon.com (AMZN) made a low of $160.39 on March 18, 2011 (point 1), and then rallied to a high of $206.39 in early May (point 2). During the rest of May and into June, AMZN made a series of lower lows (line b).
Those that bought after either the first or second decline were likely stopped out, as the final correction low (point 3) was at $181.59. This was just below the 50% support at $183.49, but held well above the 61.8% retracement support of $178.08.
From the late May high, the upper boundary of the flag formation (line a) was drawn. This resistance was broken one day before the low, but not on a closing basis.
Buying at the 50% support with a stop 0.5% under the 61.8% level was a risk of $183.49 - $177.18 = $6.31. The upside target would have been either the prior high of $206.39 or the 127.2% retracement resistance at $213.44 that was based on the decline from point 2 to point 3. Therefore, the potential rewards ranged from $22.90 to $29.95, making for a favorable risk-reward on the trade.
Apple (AAPL) is a stock that consistently gets lots of media and investor attention. In early July, AAPL overcame the five-month downtrend (line c) and accelerated to the upside. It eventually hit a high of $404.50, as their earnings beat all expectations, causing a buying frenzy.
Those that bought on the earnings were quickly disappointed. Nine days later, AAPL hit a low of $353.02. This was a 12.7% decline from the highs. The 50% retracement support at $357.50 was broken before AAPL once again rallied sharply back to $384. At this point a flag formation (line e and f) was evident.
The 50% support and line f were again tested before AAPL was able to rally above its prior highs, reaching $392.08 before last week’s decline. This created a broader flag formation (lines d and f). A convincing close above $392.08 will complete the larger flag formation.
Those who bought the secondary test of the 50% support at $357.50 could have either used a stop 0.5% under the prior low or 0.5 % under the 61.8% support at $346.40. In the first instance, the risk would have been approximately $6.25, while using the wider stop would have had a risk of $12.80.
The potential upside targets were either $404.50 or the 127.2% retracement resistance target of $418.90. The potential reward was therefore $47 or $61.50. Therefore, with either stop this strategy had a decent risk-reward profile.
The same approach can, of course, be used on weekly or even hourly flag formations. I am a strong advocate of scaling out of positions, and after a position is established I will typically place an order to close out half just under the 127.2% retracement target. If there is a significant reference point on the chart, I may put it even lower.
Also, once a triangle has been completed, I will often raise my initial stop to further limit the risk.
I hope this discussion will help you look at charts in a slightly different way. It is often very hard to identify major bottoms or tops, but once they have been completed, flag formations can help you find many good risk-reward entry points within the major trend.