Cup and Handle Pattern
How the Cup and Handle Pattern Works
A cup and handle pattern occurs when the underlying asset forms a chart that resembles a cup in the shape of a U, and a handle represented by a slight downward trend after the cup.
The shape is formed when there’s a price wave down, which is then followed by a stabilization period, followed again by a rally of approximately the same size as the prior trend. This price action is what forms the identifying cup and handle shape.
William O’Neil initially recognized this popular stock chart pattern in 1988. To identify the cup and handle formation O’Neil claims the handle should extend no longer than one-fifth to one-quarter the length of the cup. The handle will remain close to the prior highs, which will squeeze out the short-sellers and cause new buyers to enter the market.
The formation is usually initiated by low-trading volume, followed by high-volume as the left lip forms, then falling volume near the bottom of the cup, which then kicks off to rising volume towards the right lip and on the breakout. This process can last anywhere from a few minutes to sixty-five weeks, initiated by a downward price fluctuation followed by a period of stabilization, then a rally that brings the prices back up almost or equal to the previous level before the plummet.
Once this happens, the the cup advances and forms a U, and the price drifts downward slightly forming the handle.
The handle has to be smaller than the cup and should only indicate a slight downward trend within the trading range – not one that goes lower than one-third of the way into the cup. Investors who see a similar pattern where the handle goes deeper might want to make efforts to avoid it.
However, when the handle is of proper proportions to the side of the cup, a breakout that goes higher than the handle is an indication of a rise in price. Furthermore, it is essential to note that this isn’t always the case, and investors should use some measures to mitigate losses when putting money into these types of patterns.
How to Trade the Cup and Handle Pattern
Trading security based on chart patterns is quite a common phenomenon in the market. This is usually formed when the price of a security moves in a fashion which resembles a shape in the form of a rectangle, rounding, triangle, cup and handle pattern, etc.
The good thing about the pattern is that they can be easily located along with a proper entry point with predefined risk-reward.
The cup and handle pattern is an effective combination to flush out weak holders.
To trade the cup and handle pattern, wait for technical levels of resistance to break. There are two areas where traders can buy the resistance break.
First, draw a resistance trend line encompassing the high prices of the handle. A break at the resistance trend line is your signal to buy. The second opportunity to buy is a break above the high of the handle. Waiting for a break above the handle’s high is a more conservative approach, as you are seeking confirmation from the market that the price is hitting new highs.
The risk and stop loss on the trade will be set at the low of the handle. This way, if the breakout fails and falls back below the handle’s low, then you can close out the trade at a small loss and move on to the next opportunity.
If the breakout is successful, then you can consider moving your stop loss to the breakeven level, locking in the trade without experiencing a loss.
The target for the cup and handle pattern is fairly simple. Measure the distance from the cup high to the cup low and project that same distance beginning at the handle’s low point. So long as the handle remains in the upper half of the cup, this level of price projection leads to an attractive risk-to-reward ratio on the trade.
Conclusion
The cup and handle pattern is a bullish continuation pattern triggered by consolidation after a strong upward trend. The pattern takes some time to develop, but is relatively straightforward to recognize and trade on once it forms. As with all chart patterns, trading volume and additional indicators should be used to confirm a breakout and continuation of the original bullish price movement.