What is a pennant chart pattern in technical analysis?

What is a pennant?

In technical analysis, a pennant is a type of continuation pattern. It is formed when there is a large movement in a security, known as the flagpole. Then the flagpole is followed by a period of consolidation with converging trend lines – the pennant – followed by a breakout move in the same direction as the initial big move, representing the second half of the flagpole.

Understand pennants

Pennants, which are similar to flags in terms of structure, have converging trend lines during their consolidation period and last from one to three weeks. The volume at each period of the pennant is also important. The initial move should be met with large volume while the pennant should have weakening volume followed by a large increase in volume during the breakout.

Here is an example of what a pennant looks like:

In the image above, the flagpole represents the previous trend higher, the period of consolidation forms a pennant pattern, and traders are watching for a breakout of the upper trend line of the symmetrical triangle.

Many traders look for new long or short positions after a breakout of the pennant chart pattern. For example, a trader might see a bullish pennant forming and place a limit buy order just above the pennant’s upper trend line. When the security breaks out, the trader can look for above-average volume to confirm that pattern and hold the position until it reaches its price target.

The price target for pennants is often established by applying the initial flagpole height to the point where the price breaks out of the pennant. For example, if a stock rises from $5.00 to $10.00 in a sharp rally, consolidates to around $8.50, and then breaks out of the pennant at $9.00, a trader might set a $14.00 price target on the position search – or $5.00 plus $9.00. The stop loss level is often set at the lowest point of the pennant pattern, as a breakdown of these levels will invalidate the pattern and may signal the beginning of a longer-term reversal.

Most traders use pennants in conjunction with other chart patterns or technical indicators that act as confirmation. For example, traders can watch for relative strength index (RSI) levels to moderate during the consolidation phase and reach oversold levels, opening the door for a potential move higher. In other cases, the consolidation may occur near trendline resistance levels, where a breakout may create a new support level.

Limitations of pennant chart pattern

Pennant trading has several disadvantages that traders should be aware of. One common mistake is premature market entry. Some traders may initiate positions too early and try to anticipate the breakout before it actually occurs. This impatience can lead to entering trades during the consolidation phase which increases the risk of false signals.

Another pitfall in pennant trading involves the neglect of broader market context. Traders may only focus on the pennant pattern without considering external factors that may affect the trade. For example, consider broader economic events can affect more than just one security. Stocks may show their hand and show where they may be headed, but events beyond the company’s control can counter the expected price movement.

The final downside to consider is the problem of overlooking risk. Failure to set appropriate stop loss orders or neglecting position size can expose traders to excessive or unnecessary risk. Traders must establish clear risk-reward ratios and diversify their portfolios to mitigate risks associated with individual transactions.

Failed pennant formations

There are several reasons why a pennant pattern can fail. One common reason is a lack of confirmation from other technical indicators. As mentioned in the last section, traders often make the mistake of relying solely on the pennant pattern without considering additional signals from indicators such as volume, momentum oscillators or trend lines.

For example, low volume during the pennant formation can be a red flag. This is because it means poor market participation and a greater likelihood that the pattern will not produce the expected price movement.

Another reason for failed pennant patterns is external market events or news that override the technical signals provided by the pattern. Unexpected announcements, geopolitical events or economic data releases can quickly change market sentiment, making the pennant pattern obsolete. Also mentioned above, there can be broader market considerations that cause pennant formations to fail to form.

Psychology of pennant formations

Traders may choose to trade pennant formations because pennants correspond to the trader’s psychology. In either case, understanding the psychological factors behind pennant patterns can provide valuable insights for traders looking to make informed decisions.

The formation of pennant patterns in price charts reflects the ebb and flow of investor sentiment and the tug of war between bulls and bears. Pennants are typically seen as a manifestation of a temporary pause or consolidation in the market, and the psychological dynamics during this phase contribute to the pattern’s formation.

One important psychological factor that drives pennant patterns is the concept of market indecision. After a significant price move, either up or down, traders and investors can take a moment to think carefully about their positions. This period of consolidation represents a temporary equilibrium, where buyers and sellers are in a state of uncertainty.

By being attuned to the emotional dynamics that drive pennant formations, traders can improve their ability to navigate these patterns and capitalize on the subsequent price movements.

Example of a pennant

Let’s look at a real example of a pennant:

In the above example, the stock creates a pennant when it breaks out, experiences a period of consolidation and then breaks out higher. The upper trendline resistance trendline of the pennant also corresponds to reaction highs. Traders could have looked for a breakout from these levels as a buying opportunity and profited from the subsequent breakout.

Flags vs pennants

Pennants and flag patterns are often confused for each other as they look similar, but they have distinct characteristics that traders must understand in order to make accurate technical analyses.

Pennants are characterized by converging trend lines that form a small symmetrical triangle. The converging lines indicate a temporary consolidation or pause in the market before a potential continuation of the existing trend. The price movement within a pennant usually has low volatility, and the breakout of the pattern is typically accompanied by an increase in trading volume.

On the other hand, flags display a more rectangular shape. It can also sometimes look like a small parallel channel. The parallel trend lines in a flag pattern indicate a short consolidation, with the price moving in a channel against the prevailing trend. Like pennants, flags are typically seen as a continuation pattern, and the breakout direction is expected to match the existing trend.

To most easily see the difference between a pennant and a flag, look at the slope of the trend lines. Pennants have trend lines that converge to form a symmetrical triangle, while flags have parallel trend lines that create a rectangular shape. If you’re not sure which is which, look at the slopes of each.

The Bottom Line

Pennant formations are short-term continuation patterns identified on price charts. They are characterized by a small symmetrical triangle created by converging trend lines. Traders often use pennant formations to anticipate breakouts, with the height of the initial strong move providing an estimate for potential price targets.