We'll start with this:
It will extend the transparent background of your image, like this:
Next, let's go to your colour wheel. Next to Primary/Secondary, there is a box that says "More". Click that box and your colour wheel will extend out. Place in the setting, as shown below:
In your layers box, add a new layer:
On this uppermost layer, you need to use your paint bucket to flood fill it a light grey:
Now, add a third layer to your layers box:
Find your paintbrush in your drop down menu and set it to brush size 70:
(NOTE: I found it easier to uncheck my grey layer so I could see the flag so I could eyeball where I wanted my waves.)
This box will come up. Use this setting:
While on your transparent layer, MERGE it with the grey layer:
While you are on your merged grey layer, use "Control A" on your keyboard to select all and then "Control C" on your keyboard to copy. Now, go to Edit > Paste In To New Image.
You'll see it come up in your toolbar. Save this as a PNG where you can find it.
Now, un-check your uppermost grey layer.
Go to your flag layer. Go to Effects > Alpha-Displacement.
This box will pop up:
Now, your layers box looks like this:
Making sure the box layer is checked in your box, go to properties.
Use these settings when the box pops up:
It will look like this:
Merge layers down.
Use these setting on drop shadow to highlight the flag.
Now crop and save as a PNG and you're done.