What Is a Cup and Handle Pattern?
Chart patterns, like a triangle, rectangle, head and shoulders, or—in this case—a cup and handle are a visual way to trade. The cup and handle pattern, also sometimes known as the cup with handle pattern was first identified by stockbroker William O’Neil in 1988. The cup and handle pattern occurs when the price of an asset trends downward, followed by a stabilizing period. Prices then rise to an approximately equal size to the prior decline. It creates a U-shape or the “cup” in the “cup and handle.” The price then moves sideways or drifts downward within a small price range, forming the handle. For example, if a cup forms between $99 and $100, the handle should form between $100 and $99.50, ideally between $100 and $99.65. If the handle dives too deep and erases most of the gains of the cup, you should avoid trading the pattern. This pattern can occur both in small time frames, like a one-minute chart, as well as in larger time frames, like daily, weekly, and monthly charts. A cup and handle chart usually signals a bullish continuation pattern. A continuation pattern occurs during an uptrend; the price rises, forms a cup and handle, and then continues rising. In some cases, the pattern may indicate a reversal when the price is in a long-term downtrend. It then forms a cup and handle that reverses the trend, and the price starts rising.
Entering a Cup and Handle Trade
You’ve identified a cup and handle pattern, but before you jump into the trade, you must wait for a handle to form completely. The handle often takes the form of a sideways or descending channel or a triangle pattern. When the price breaks out of the handle, the pattern is considered complete, and the price is expected to rise. So, when a good time to buy? The answer is in the chart. A good time to buy is when the price of the asset moves up and exceeds the price levels seen previously at the top of the right side of the cup. In addition to the price levels, some traders also look at trade volume in the asset before entering a trade after a cup and handle pattern. Higher volume indicated that more investors are buying that asset, and higher demand could lead to higher prices in the near future.
Protect Your Trade With a Stop-Loss
A stop-loss order gets a trader out of a trade if the price drops, instead of rallying, after buying a breakout from the cup and handle formation. The stop-loss controls risk on the trade by selling the position if the price declines enough to invalidate the pattern. Place a stop-loss below the lowest point of the handle. If the price oscillated up and down several times within the handle, a stop-loss might also be placed below the most recent swing low. Since the handle must occur within the upper half of the cup, a properly placed stop-loss should not end up in the lower half of the cup formation. For example, suppose a cup forms between $50 and $49.50. The stop-loss should be above $49.75 because that is the halfway point of the cup. By having the handle and stop-loss in the upper third (or upper half) of the cup, the stop-loss stays closer to the entry point, which helps improve the risk-reward ratio of the trade. The stop-loss represents the risk portion of the trade, while the target represents the reward portion.
Picking a Target Price or Profitable Exit
Whatever the height of the cup is, add it to the breakout point of the handle. That figure is the price target. For example, if the cup forms between $100 and $99 and the breakout point is $100, the target is $101. A conservative price target can be achieved by measuring the height of the handle and adding it above the resistance level at the top right-side of the cup. Sometimes, the left side of the cup is a different height than the right. Use the smaller height and add it to the breakout point for a conservative target. You could also use the larger height for an aggressive target. If you’re day trading, and the target is not reached by the end of the day, close the position before the market closes for the day.
Other Important Considerations
Traditionally, the cup has a pause, or stabilizing period, at the bottom of the cup, where the price moves sideways or forms a rounded bottom. It shows the price found a support level and couldn’t drop below it. It helps improve the odds of the price moving higher after the breakout. A V-bottom, where the price drops and then sharply rallies, may also form a cup. Some traders like these types of cups, while others avoid them. Those that like them see the V-bottom as a sharp reversal of the downtrend, which shows buyers stepped in aggressively on the right side of the pattern. If the trend is up and the cup and handle form in the middle of that trend, the buy signal has the added benefit of the overall trend. In this case, look for a strong trend heading into the cup and handle. For additional confirmation, look for the bottom of the cup to align with a longer-term support level, such as a rising trendline or moving average. If the cup and handle form after a downtrend, it could signal a reversal of the trend. To improve the odds of the pattern resulting in an actual reversal, look for the downside price waves to get smaller heading into the cup and handle. The smaller down waves heading into the cup and handle provide evidence that selling is tapering off, which improves the odds of an upside move if the price breaks above the handle. Another related technical analysis indicator to keep in mind is an inverted cup and handle pattern. Some traders consider that pattern a harbinger of a downtrend in the asset’s price that helps identifying selling opportunities. On the charts it looks like an upside down cup with the price of an asset on a downward trajectory moving up, stabilizing and then moving down again, followed by a handle pointing upwards. Most of the same general rules, such as the handle not exceeding 1/3rd of the cup, still apply. The price of the asset is expected to drop after the pattern formation is complete.
