A chart pattern extensively used by traders is the cup and handle pattern. This pattern visually resembles a U-shaped cup with a slightly downward drifting handle. It is used to identify good buying opportunities and book profits, especially in the long term. The cup and handle chart pattern marks a consolidation period in a stock followed by a breakout and suggests a continuation of the uptrend in a security’s price movement.
This blog is a comprehensive guide on cup and handle pattern, how to identify it, its example, interpretation and the psychology behind it. Read on!
A cup and handle pattern is a technical chart pattern signalling a bullish continuation in a security’s price movement. It is a prediction that the security’s price will move upward following a breakout. First described by William O’Neil in his book ‘How to Make Money in Stocks’ in 1988, the formation of this chart pattern depicts a good buying opportunity.
As the name suggests, cup and handle chart patterns resemble a cup and a handle. The U-shaped cup looks like a bowl or a round bottom. The handle is a smaller cup formed after the completion of the cup and is generally followed by a breakout. The pattern may take anywhere between seven to sixty-five weeks to form.
In the securities market, recognising the cup and handle chart can be a fruitful exercise to make gains.
The cup always precedes the handle in this chart pattern. The cup pattern in trading forms after an initial uptrend. As stocks attain new highs, there is selling pressure among investors to book profits, causing the price to fall. The formation of the base or rounding bottom of the cup marks a period of stabilisation. The price then rises during the rally approximately to the level of the previous advance, thus completing the cup.
Once the cup pattern in the chart completes, the handle forms as the price stalls or moves downwards. The pullback is ideally less than or equivalent to 1/3rd of the prior advance. It marks a slightly downward or sideways price movement and then an uptrend that pushes past the resistance level causing a breakout.
Identifying the cup and handle chart pattern can be complicated, even if you know what you are looking for. The cup and handle pattern is not an exact science. Several things can help you identify this bullish continuation pattern, particularly the shape of the chart pattern.
For instance, a perfect cup pattern has equal highs on both ends (although this does not always hold). It may take between four to six months to form. An important thing to remember is that the handle forms on the right side of the cup. It signifies a pullback before the breakout in the stock price. However, the pattern must be complete, as instances of the cup and handle pattern failure are not uncommon.
Let’s look at an example of what the trends in a cup and handle pattern look like.
Imagine that stock A has witnessed an upward price trend from Rs.75 to Rs.90, completing the left edge of the cup. Due to selling pressure, the price of stock A falls to Rs.80, reversing the prior uptrend. The price remains stable at this point, creating the base of the cup that is the support. However, after the period of consolidation, the stock witnessed another uptrend creating the right edge of the cup. At the high point, it achieves the price of Rs.90.5, recovering from the downtrend that started a few months prior.
Here, it hits the resistance level, and the handle starts forming. It may resemble a flag or a pennant with a slightly downward slope, or it may be a short pullback from the preceding top. At its lowest point, stock A retraces its previous gains and reaches a price of Rs.85. After a few weeks, the stock is able to breach its resistance level and breakout to a new high of Rs.105.
Interpreting cup and handle patterns in a chart is essential to any trader worth their salt. To make the process easier, let’s break down the reading of the technical indicator into the following parts:
The shape of the cup, particularly the bottom of the cup, can reveal how the market interacts with security. An ideal cup will have a rounding bottom, indicating consolidation. A perfect cup has equal highs on both edges. However, these ideal conditions may not emerge as highs can differ, and the cup may instead form a V-shaped pattern, suggesting a sharp reversal.
The cup should have a shallow bottom and not be too deep. The same applies to the handle, as it is supposed to form in the top half of the cup’s pattern. It helps ensure that the stock finds good price support.
The pullback after the completion of the cup forms the handle. The downward trend in the handle should not typically breach the 1/3 mark of the cup’s advance. During a more bullish signal, the retracement will be smaller, and the breakout will be more significant. The volume of trade increases substantially once the stock breakouts by breaching the stock’s resistance level.
The volume of trade should move along with the price of the stock. As the price of a stock declines, it should drop, too. As the base of the cup forms, the volume should remain lower than the average. As the price rises, the volume of trade should also increase.
The first step toward trading the cup and handle pattern is to enter a long position. One should enter the trade by examining the point at which the breakout happens, that is, the price crosses the channel or triangle pattern of the handle. At this moment, the pattern is complete, with an expectation that the price will rise.
The stop-loss ideally should be on the upper-third end of the cup and placed at the lowest point of the handle. When the handle witnesses multiple swings in price, the stop-loss is placed at the bottom of the most recent swing. The exit point in the trade is estimated based on the target. A general estimate of a cup and handle pattern target is the height of the cup and the height of the handle’s breakout point. However, depending on the price movement, the target may shift.
The inverted cup and handle pattern is in direct contrast to the cup and handle pattern.
It signifies a bearish continuation pattern with a downward breakout in the price movement. The inverse cup and handle pattern is the reversal of an upward price movement during which the asset price drops after reaching a peak. It leads to the creation of an upside-down cup pattern chart, after which the price rallies to near-previous levels. However, the price declines after the high as the breakout occurs when the price level breaches the support.
As the price breaks below the handle, the trader should ideally exit their long-term positions or enter the trade during the short term. A stop-loss is necessary here, too, and is generally placed above the handle. The reverse cup and handle pattern is most visible in bear markets and during intraday time frames.
The cup and handle pattern psychology is interesting to explore. You can see how volumes and fear of price fall can cause great up-and-down swings in a stock price.
In the cup and handle pattern, as the stock price moves upwards, there is selling pressure among investors who want to consolidate their profits at new highs. As a result, there is a downward spiral in the price movement and a price correction. Bulls or buyers start accumulating the stock for long positions as speculators leave their positions. There is an increase in volume at this stage as the U-shaped bottom gives way to an uptrend, creating the second edge of the cup.
Traders begin to sell at this high point corresponding to the left edge of the cup, creating a resistance level. At this selling point, the handle or the pullback portion of the chart pattern takes shape. If the price can breach the resistance level, the stock witnesses a breakout. Traders are bullish at this point, signified by an increase in the trade volume. As a result, they push the stock price even higher as the breakout gathers strength.
Ultimately, investor sentiment makes or breaks the pattern and its formation.
Investors need to establish stop-losses and profit targets to make profitable entries and exit from a trade position. Let us look at what stop-losses and profit targets entail for cup and handle patterns.
A stop-loss controls the trade risk by establishing a level at which the trader should exit the trade (if the price drops instead of rising). In the cup and handle chart pattern, a stop-loss is placed at the lowest point of the handle or the lowest point of the most recent swing. The stop-loss is usually located in the upper third part of the cup, corresponding to the position of the handle.
Per the risk-reward ratio for a trader, profit targets determine the reward aspect. The cup and handle pattern target generally requires adding the height of the cup to the breakout point in the handle. Depending on whether the trader wants to make conservative or aggressive targets, they can lower or increase the height to decide the exit position.
For traders, chart patterns are critical technical indicators that can help them predict price movements. The cup and handle pattern is one of the most popular forms of technical analysis that signifies a bullish trend. The pattern comprises the cup and the handle and resembles them in appearance. The cup and handle breakout point is when the pattern is complete, and traders can expect a continuation of the price uptrend. For the novice and the experienced trader, this chart pattern can help determine points of entry and exit in a trade.
Ans: The bullish continuation pattern(the basis of the cup and handle pattern) indicates that the uptrend in the security’s price will continue with the bulls maintaining control.
Ans: On completion of the cup and handle pattern, there is a breakout which leads to a rise in the security’s price in continuation of the preceding bullish pattern. Conversely, a breakout on the downside can occur in the case of an inverted cup and handle pattern.
Ans: The cup and handle pattern may be challenging to identify for the novice. The pattern varies depending on: the depth and shape of the cup, the duration of the timeframe, broader market trends and such variable factors. The entire pattern needs to form fully (which takes a long time), and buying opportunities are determined based on analysis of the pattern with other market indicators, i.e. it cannot be used in isolation.
Ans: A U-shaped cup and handle pattern with a shallow bottom is the most stable form of the pattern as it indicates market consolidation. On the other hand, traders generally avoid the V-shaped bottom as it may cause sharp reversals in the price movement.
Ans: The cup and handle pattern can last anywhere between seven to sixty-five weeks. Therefore, the timeframe of this pattern is long and varies depending on multiple factors, such as prevailing market sentiments and trends.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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