Cup and Handle Pattern

Last Updated: 18 Nov 2024

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 a 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 experiences 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 and introduced in his 1988 book – ‘How to Make Money in Stocks’.

Understanding the cup and handle pattern

A cup and handle chart may 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, forms a cup and handle, and then continues to rise.

Source: elearnmarkets

Source: elearnmarkets

It offers dealers precious views into the underlying market sentiments and potential future price fluctuations. Here are some things you can learn from this sample:

• Bullish continuation: The cup and deal with pattern is actually a bullish continuation design, proposing that the uptrend is very likely to resume following the sample formation finishes. This offers an excellent chance for dealers to enter prolonged positions.
• Market strength: The pattern displays a brief period of consolidation, indicating that the promote is taking a break prior to continuing its upward momentum. This showcases the underlying power of your promote.
• Price targets: By calculating the scale of the cup from the underside to the rim and including it to the breakout point, dealers can estimate a possible price and aim for a subsequent uptrend.

Cup and handle pattern rules  

• It must be like a cup and should curve in the form of U. The left side of the cup should appear relatively straight, while the right side should curve up.
• The depth of the cup must be at least one-third of the previous uptrend.
• After the formation of the cup, there must be a handle formation that would look like a small consolidation period. The handle is a downward-sloping channel, usually taking up to 1/3 of the cup height.
• There must be a volume pattern. The volume in the first breakout should be high and then low-volume consolidation.
• An entry based upon an attempt for a breakout from out of a handle formation in higher volume than average signifies an advance in buying pressure.

How to trade the cup and handle

Trading the cup and handle demands close attention and a concrete strategy. Here’s a step-by-step on how one can effectively trade this pattern:

• Identify the Cup Formation: Find a cup formation on the price chart. It would appear like a rounded bottom in the shape of a “U.” The bottom should have a smooth and gradual fall to indicate temporary price correction.
• Confirm the Handle Formation: Once the cup has been identified, look for handle formation. The handle should have a minor downward consolidation, which forms a minor decline and then a consolidation range.
• Entry Point: Place the trade when the price breaks above the handle-created resistance level. Such a breakout confirms the pattern and, therefore, marks a resumption of the uptrend.
• Stop Loss and Take Profit: A stop-loss order should be set below the handle’s support level so that the loss is restricted. The take-profit level may be calculated by adding the depth of the cup to the breakout point.
• Volume Confirmation: Monitor volume on the breakout. More and greater trading volume should correlate with the breakout, while the high-interest buying level makes sense and justifies the whole pattern’s reliability.
• Monitor Price Action: Monitor the price action after entering the trade and continuously. You might need to trail your stop loss to protect profits and adjust your take-profit target if necessary.

Example of trading in the cup and handle pattern

Consider finding a cup and handle pattern in the ABC Ltd. stock chart. First, it’s upward in a rounded shape known as a “cup”. Then comes a smaller decline referred to as a “handle”. The resistance point is around ₹200. When this breaks ₹200 with high trading volume, one may buy shares on this pattern, expecting further movement upwards. 

The risk of the trade is managed by setting a stop-loss below the low of the handle, for example, at ₹190. In case of a breakout, the target profit may be set by the depth of the cup, which is often exited when the price hits about ₹230.

Limitations of the cup and handle pattern

The cup and handle pattern is quite strong. But it does not come without certain shortcomings. 

• False Signals: Even the best technical patterns can be inaccurate at times. Hence, before starting trading, always look for supplementary indicators or confirmatory signs for validation.
• Market Conditions: The pattern may act according to the prevailing market conditions. Considering other supportive factors, such as market trends and volatility, before taking trading decisions will be the key.
• Selection of Timeframe: The cup and handle pattern is reliable on longer-term charts. It may not be that effective or even prominent on intraday charts.

Important points to keep in mind

In a nutshell, here are the essential points to consider in evaluating and trading the cup and handle pattern:

• It is a bullish continuation pattern
• It reflects a brief dip followed by a slow recovery
• The handle indicates a minor consolidation before the price advances further.
• The pattern yields information about the market trend and the price target.
• Trading with the cup and handle pattern means you need to go long upon the breakout and then position your stop-loss and take profit accordingly.
• Verify with volume and also use some other indicators to confirm it.
• The pattern gives excellent entry and exit points and optimised risk-reward ratio along with most timeframes to be traded.
• However, a trader should be able to identify false signals and assess market conditions properly.

Conclusion

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

Frequently Asked Questions

Is a cup and handle pattern bullish?

A cup and handle are considered a bullish signal extending toward an uptrend, and is used to spot opportunities to go long.

How do you find a cup and handle patterns?

Consider a scenario where stocks recently peaked after a significant shock, but then corrected and fell nearly 50%. At this stage, investors can buy stocks in the hope that they will return to their previous levels. The stock tests a previous high resistance level to revert and then moves down in a consolidation trend. In the final phase of the pattern, stocks have crossed these resistance levels and surged 50% from their previous highs.

What is the success rate of a cup and handle pattern?

The cup and handle pattern usually performs well under various market conditions and time frames. When viewed correctly, the estimated success rate is around 65-75%. It’s considered somewhat reliable when compared with other technical indicators, but no pattern ever has a 100% chance of occurring.

How do you predict a cup and handle pattern?

The pattern can be anticipated by looking at the rounded “U” that is followed by a smaller depression, similar to a handle. Often, it follows an upward trend and, if supported by volume, confirms potential continuation if the price is broken above the resistance line of the handle.

Can a cup and handle pattern fail?

Yes, the cup and handle pattern can fail if the breakout above the handle’s resistance does not hold. It can be a false signal in case of increased market volatility, weak volume during breakout, or some broader economic factors, and instead of continuation, the trend reverses.