
2
– Creating a Gradient
Now
make a new image, the same size as your first image.
Select the "Gradient" tool, and edit the
gradient (Click on the visual representation of the gradient, or click
on "Edit" on the Options tab.) Put in lots of black and white markers, as I've done in the image
(this will make your gradient produce black and white bars).

3
– Applying the Gradient
Hold down Shift, and apply the gradient across your new
image from left to right.

4
– Softening the Gradient
Click
Filter > Blur > Gaussian Blur, and blur your image a bit. This image is now your "displacement
map". Save this image (I generally use the name
"dispmap.psd").

5
– Applying the Displacement Map
Now go back to your original
flag image, and click Filter > Distort > Displace. Put 0% in "Horizontal Scale" and 5% in "Vertical Scale". (You can go
higher if you want the waves to be bigger.) When it asks for a file, select your displacement map. (This will distort your image depending on how dark the displacement map is at that point.)

6
– Bringing in the Displacement Map
Now grab your displacement map image, and drag it onto your image. Use the arrow keys to nudge the displacement map until it covers the whole image.

7
– Using an Overlay to Create Some Light
Change
the displacement map layer's Mode from Normal to Overlay, and reduce its opacity (75% is good).
Voila, a funky flag.
Scroll up and compare this image to the first one, and you'll really notice the
difference.
This technique can also be used to make realistic curtains, ribbons, and banners.