How's it work? Is there a flag system somewhere?
No flag system.
The horizontal arm is attached to the vertical post with a door stopper spring(white in this case). At the bottom of the black line is a swivel. To this you attach a piece of mono to your hooks and weight. You lower your weight to the bottom or somewhere between surface & bottom. With the correct weight the vertical arm will be level or slightly below level. Now you tighten the reel so that the line will only pull out under firmer pulls.
If the bait is lifted the arm raises & if the bait is pulled down or ran with the arm goes down. This is the reason for the colored arm to see the hits.
As the door stopper spring is not that firm this system is quite sensitive to light bites.
