Make sure your flag is on its own layer and you have some room around the flag to work with.

Make a selection of about 95% of the flag to the RIGHT, leaving only about 5% of the flag on the left unselected (see picture below).

Now go to Select->Feather and enter 50px.
Choose the flag as the working layer and go to Filter->Distort->Wave:


Note:The reason we use the feather and selection in the above step is so we apply the wave to the flag, while leaving the left edge of the flag slightly straight, in case we want to hang it on a pole. Without the selection step above, the left end of the flag would look something like the right end of the flag, which is not very realistic.
- Create a new layer. Set your foreground color to
dark grey (#575757)
- Next we want to apply some shadows to the flag. Use
the brush
tool


Now apply the wave filter to it. Filter->Distort->Wave:


Now go to Filter->Blur->Guassian Blur. Set radius=9

Now set the blending mode of the shadow layer to "Soft Light"
Here is mine with a pole attached. (download .PSD file)













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