Chart Patterns: Cup And Handle

The cup and handle chart pattern is a forex chart formation that's well-known as a signal foreshadowing an upward price continuation following market hesitation, and a test toward a possible downward move. Contrary to downtrend indicators, it may be used to "go long" and buy conventional securities or derivative products. The first observation of the formation is attributed to publisher William O'Neil, the founder of Investor's Business Daily, who originally described the pattern in the 1980s.^[1]

Since then, the cup and handle formation has become a storied aspect of the financial markets. From day trading to long-term investment strategies, active traders from around the globe have made it a valued part of their technical analysis.

How Does Cup And Handle Formation Form?

The cup and handle formation may seem peculiar and less obvious than some of its counterparts, such as the double or triple bottoms that show more linear components. The pattern typically begins following an uptrend in price, with a downward price movement (the left side of the "cup") showing a decline in conviction among investors. Subsequently, the bearish sentiment prompts a pullback in price and signals that sellers are winning the battle versus buyers.

Structurally, the price declines and then begins to decelerate and flatten out in the middle of the pattern. This is largely due to bearish sentiment weakening and bulls going to work against possible further price declines. After the price flattens out, bulls regain the upper hand and price begins to gradually move upward. This culminates in a sharp upward movement that forms the right side of the cup.

It's important that the bottom of the cup pattern appears as a U-shape, because if the pattern appears in a V-shape, a subsequent breakout is less likely to prosper. The rounding bottom price action suggests that the market has entered a slight consolidation stage. Once the formation reaches the level of the previous high seen at the left side of the cup, price will flatten out into a slightly downward but mostly horizontal "handle." The handle is indicative of some hesitation among investors about the continued strength of the upward movement.

The formation of the handle is an important detail that will determine the strength and likelihood of a further move upward. Generally, the handle may move downward to about one-third of the height of the cup formation to be considered a continuation signal. However, it shouldn't move to more than one-half the size of the cup formation. A shallower and longer handle is seen as a stronger signal of an impending upward breakout, because it gives time to shake out any traders who lack conviction of further upward price moves.^[2]

Monitoring Volume

As with most breakout patterns that form in the financial markets, it's important to monitor the volume of trading to help confirm the various components of the cup and handle. Generally, an increase in traded volumes suggests growing market participation and public interest. Catalysts for the boosted participation may range from a surprise news event to the presence of a key market technical. The result of enhanced volumes can be growing volatility or a sudden, directional move in price action.

For the cup and handle, growing volumes are especially important at the end of the pattern when the handle forms. At the point of the breakout and once the end of the handle is reached, volume will spike to around 50% above the 50-day average.^[2] The 50% uptick in volume on the daily time frame is a key observation when determining the validity of the cup and handle pattern.

How To Trade The Cup And Handle

The formation of the handle offers traders an opportunity to prepare for a potential top-side breakout. In this way, the cup and handle is periodically viewed as a bullish continuation pattern. Once the cup pattern forms, traders can look to place a protective stop loss below the handle at one-third or one-half retracement of the cup.

A profit target can be set above the cup at twice its height. Thus, the depth of the cup has a direct bearing on how strong bullish price breaks are expected to be. A strong pick-up in volume will serve as an entry signal for the trade, and a good entry point can be slightly above the highest point of the handle.^[3] By structuring the trade using the handle as a reference point, a precise stop loss and profit price target can be located.

The Full Cup And Handle Doesn't Always Form

At times, the cup and handle may not fully develop, and only the cup forms. The cup signal, however, is essentially the same as the cup and handle. The main difference is that the entry price level for a trade will be different. In the case the right portion of the cup formation extends above the left without flattening to a handle, traders can enter the trade shortly thereafter upon a strong surge in volume.^[4]

Also, it's important to realise that the cup and handle pattern is only one form of technical analysis. In practice, there are many others that may prove complimentary. A few indicators that you can use in concert with the pattern are Fibonacci extensions, the inverted cup, as well as the double top or bottom and moving average. While the application of each will vary, all furnish the trader with valuable insight into the tendencies of price action.

Summary

The cup and handle has been found to be a reliable indicator of a bullish trend continuation. It is most commonly utilised on an intraday, day, or weekly chart. Although it is utilised in a diverse array of trading strategies, the cup and handle does have a collection of standard benefits. One special advantage of the formation is that it allows traders time to pause and set up well-positioned entry and exit points for a bullish breakout once the pattern begins to emerge. This is a key bonus and one that makes the cup and handle superior to broader indicators such as a simple trendline.

As with analysis of all chart patterns, the cup and handle requires special attention to price movements and volume signals before a successful trade can be carried out. Nonetheless, when carefully scrutinised, it is a powerful bullish continuation signal that may be used to enter the long-side of the market.