fbpx

What Is a Cup and Handle Pattern?

A cup and handle pattern is a technical indicator used by some traders to identify bullish patterns in the market. Using this indicator, traders try to find opportunities to go long and make a profit on an anticipated uptrend. There are several nuances to this indicator, and understanding them is important before using this technical tool to make trades. Explore what a cup and handle pattern is, what to consider when following this pattern, and the best ways to trade when using a cup and handle pattern.

What Is a Cup and Handle Pattern?

Image via Flickr by AndreasPoike

A cup and handle pattern is a technical indicator used as a bullish signal to detect an extending uptrend. William J. O’Neil developed and defined this pattern in his 1988 book “How to Make Money in Stocks.” Traders use this pattern to find opportunities to go long.

This technical indicator looks like a cup with a handle, with the cup portion of the pattern making a “u” shape and the handle portion of the pattern showing a minor downward drift. The right-hand portion of the pattern typically shows a lower trading volume. Most cup and handle patterns will form in as little as seven weeks, but they can take up to 65 weeks to fully present.

Traders use this visual pattern to spot trends in the market and make trades based on the pattern. This type of pattern offers a logical entry point as well as a stop-loss location (above the upper trendline in the handle area). Cup and handle patterns also show a price target where traders can exit the trade in order to make a profit.

This type of pattern occurs when the market is experiencing a downward wave, meaning stock prices move down based on investor psychology and sentiment.

What To Consider When Following the Cup and Handle Pattern

There are several components and a number of factors to consider when using this technical indicator in trading. In his book, O’Neil indicated four different stages in a cup and handle breakout:

  1. The stock or other security shows a significant high and makes an uptrend that has heightened in the last one to three months.
  2. The security’s next pullback shows a rounding bottom that’s no deeper than 50% of the retracement of the last trend, which makes the “cup” portion of the pattern.
  3. The security fails to make a breakout at the prior high and instead shows a secondary pullback that holds close to resistance, which in turn shows another rounding bottom that depicts the “handle.”
  4. The security then goes back to resistance and is successful at breaking out, showing a move target that’s equal to the bottom of the cup.

While this is the general construction of a cup and handle pattern and the original construction as set forth by O’Neil’s rules, there are several variations that traders can use to produce effective results, including multi-year patterns and even intraday patterns.

In addition to the stages of a cup and handle breakout, there are other factors to consider when following this indicator:

  • Trend: A previous trend must exist in order for the cup and handle indicator to qualify as a pattern. The older the trend, the less effective this pattern may be at showing a viable trend to follow and trade on.
  • Length: In the cup and handle pattern, cups with longer and more defined “u” bottoms are typically stronger signals.
  • Depth: Traders should avoid or be wary of cups and handles that are overly deep.
  • Volume: The volume of the cup and handle pattern should decrease as the security price declines and stay below the average of the base of the cup. The volume should increase as the stock starts to move higher.

How To Trade Using the Cup and Handle Pattern

The following are the general steps to take when trading using the cup and handle technical indicator:

Enter the Cup and Handle Trade

When trading based on a cup and handle pattern, you must first wait for the handle part to form. This will typically look like a descending triangle. [BUBBLE QUOTE] You can consider buying when the stock price goes above the upper portion of the triangle or handle. The price of the stock will typically rise when the cup and handle pattern is complete.

Set a Stop-Loss Order

Setting a stop-loss order is an important part of successfully trading using a cup and handle pattern. A stop-loss order is a tool that allows traders to sell if the price drops below a certain point. This helps to control the overall risk on the trade by enabling traders to get out of the position if the price were to drop low enough to make the pattern invalid.

Set your stop-loss order lower than the lowest portion of the handle, or around the halfway point of the cup. An ideal stop-loss will be in the upper third portion of the cup. For example, if the cup takes shape between $30 and $29.50, you’d set the stop-loss order at $29.75 as this is the halfway point in the cup pattern.

Choose a Profitable Exit or Target

To choose an appropriate target, add how high the cup is to the height of the breakout point of the handle. For example, if the cup forms between $30 and $29 and the breakout location is at $30, you could set your target to $31.

If one side of the cup is higher or lower than the other side, use the smaller height if you want a more conservative target or the bigger height if you want a more aggressive target.

If you are a day trader and using the cup and handle pattern to determine your trades for that day, close your position before the market closes for the day if you don’t reach your target. You can also use a trailing stop-loss to get out of a position that is too close to the target and begins to drop.

The Buy Point

Most cup and handle patterns indicate that the buy point is the highest point of the handle or just above the handle.

Advantages of Using a Cup and Handle Pattern

There are a few key advantages of using the cup and handle pattern when trading, including:

  • This pattern is easily identifiable by more experienced traders, making it a straightforward way to trade.
  • The cup and handle pattern shows clear entry and stop points.
  • This pattern can be used for both forex and stock markets.
  • It can be used for both day trading and long-term trading.

Disadvantages of Using a Cup and Handle Pattern

While there are certainly advantages of a cup and handle pattern, there are also potential disadvantages that traders should be aware of when using this indicator:

  • It can take a while for the cup and handle pattern to fully form, which can result in late decision-making on behalf of traders.
  • The time frame of cup and handle patterns can range from one day to several years, making this indicator occasionally ambiguous.
  • A deeper cup pattern can sometimes show a false signal, resulting in traders losing money when using this pattern.
  • The cup and handle pattern is sometimes unreliable when using it to trade illiquid stocks.
  • This technical indicator takes time and practice, so it can be challenging for more novice traders to identify.

The more familiar you are with the ins and outs of the cup and handle pattern, the more successful you’ll be at using it.