Cup and Handle Pattern

A chart pattern manifests when the price of an asset moves in a direction similar to a common shape, such as a triangle, rectangle, head and shoulder, or in this case a cup and handle. These patterns visually represent a manner of trading . It provides a logical entry point, a stop-loss location for risk management, and a target price to close a profitable trade. This article highlights what is a cup and handle pattern in stocks, how to trade, and what to look out for, to increase your chances of winning the trade.

What is ‘Cup and handle pattern’?

The cup and handle chart pattern on a security’s price chart is a technical indicator similar to a cup with a handle, where the bowl is U-shaped and the handle moves slightly downwards. The cup and handle are considered bullish signals – the right-hand side of the pattern generally experiencing lesser trade volume. The pattern's formation can take as short as 7 weeks to as long as 65 weeks.

The cup and handle chart pattern was developed by William O'Neil, introduced in his 1988 book - ‘How to Make Money in Stocks’.

Understanding the Cup and handle pattern

The cup and handle pattern occurs in small timeframes, such as 1-minute charts, and large timeframes, such as daily, weekly, and monthly charts. This occurs when there is a downward wave, followed by a stabilization period and then a rise of approximately the same magnitude as the previous decline. This makes a U-shape or a "cup". The price then moves sideways or drifts down within the channel forming the handle. The handle can even be triangular.

The handle should be smaller than the cup and not drop below the bottom half of the cup, but should ideally be in the upper third. For example, if your cup forms between Rs. 99 and Rs. 100, the handle should be between Rs. 100 and Rs. 99.50, ideally between Rs. 100 and Rs. 99.65. Pattern trading should be avoided if the handle is too deep, as this erases most of the profitability of the cup.

A cup and handle chart may also show a reversal pattern or a continuation pattern. A reversal pattern occurs when the price is on a downtrend, in the long run, forming a bowl with a handle to reverse the trend and when the price starts to rise. A continuation pattern occurs during an uptrend. The price rises, form a cup and handle, and then continues to rise.

What Does A Cup And Handle Tell You?

As the stocks that make up this pattern test old highs, it is likely to come under pressure from investors who have previously bought at this level. It is likely to consolidate into a downtrend for 4 days to 4 weeks before the price rises due to selling pressure. The cup and handle are considered a bullish continuation pattern and are used to identify buying opportunities.

It is worth noting the following when detecting cup and handle patterns:

Length: Cups that are generally longer and have a U-shaped bottom provide a stronger signal. Avoid cups with sharp V-bottoms. Depth: Ideally the cup should not be too deep. Also, avoid handles that are too deep as the handle should form the top half of the cup pattern. Volume: As the price declines, the volume should decrease and remain below average at the bottom of the bowl. The stock volume should rise as it tests its previous highs.

There is no need to retest the previous resistance to touch or exit within a few ticks of the previous high. However, the farther the top of the handle from the peak, the more significant the breakout

Entering a cup and handle trade Handles are often lateral or descending channels or triangular in shape. Buy when the price crosses the top of the channel or triangle. When the price leaves the handle, the pattern is complete and the price is expected to rise. The price is expected to rise, but that does not mean it has risen. The price may rise and fall slightly, and may move sideways or decline shortly after entry. Therefore, in this case, a stop-loss is necessary.

Setting a stop-loss A stop-loss order gets a trader out of a trade if prices drop, instead of rising, after buying a breakout from the cup and handle formation. A stop-loss is used to control the risk of a trade by selling a position when the price drops enough to negate the pattern. Place the stop-loss below the lowest point of the handle. If the price has moved up and down within the handle several times, a stop-loss can also be placed below the bottom of the most recent swing. The handle must be on the top half of the cup, therefore a prudently set stop-loss must not touch the bottom half of the cup shape. If your stop-loss is below the middle of the cup, avoid trading. Ideally, the stop loss should be in the upper third of the cup. Since the handle and stop-loss are both in the upper third (or upper half) of the cup, the stop-loss stays closer to the entry point, helping to improve the risk-reward ratio of the trade. A stop-loss is part of the trading risk and the target is part of the reward.

Picking a profitable exit

Regardless of the cup height, add that height to the breakout point of the handle. That figure is ideally the target. For example, if your cup size is between Rs. 100 and Rs. 99 and your breakout point is Rs. 100, your target is Rs. 101. Sometimes, the left and right sides of the cup have different heights. Use a lower height and add it to the breakout point for conservative targets, or use the higher height for aggressive targets. If you are a day trader and you do not reach your target by the end of the day, close your position before the market closes for the day. A trailing stop-loss can also be used to exit a position that has approached the target but is starting to fall again.

Final word

Like any or all technical indicators, the cup and handle pattern should be used in nexus with other indicators before making a trading decision.