What is the Cup & Handle Pattern And How to Trade It?

The cup and handle pattern is a popular technical analysis chart formation that suggests a bullish continuation. It resembles the shape of a tea cup:

Cup and handle pattern (Source: Equentis)

1. Cup Formation: This part of the pattern looks like a “u” shape. It starts with a gradual decline in price, followed by a rounded bottom and then a rise back to the previous high. This part typically takes several weeks to months to form.
2. Handle Formation: After the cup, the price usually pulls back slightly, forming the handle. This is a consolidation phase that can appear as a small downward or sideways movement. The handle generally forms for a shorter period than the cup.
3. Breakout: A bullish signal is generated when the price breaks above the resistance level formed by the highs of the cup. This breakout often indicates a potential upward price movement.

Traders look for confirmation through volume — ideally, volume should increase during the breakout.

Inverse Cup and Handle Pattern

Inverse cup and handle pattern (Source: Santa Monica Mirror)

The bearish version of the cup and handle formation is known as the “inverted cup and handle”. It features a similar shape but in reverse:

1. Inverted Cup Formation: The price initially rises to form a rounded top (the cup), followed by a decline that resembles a “u” shape. This formation indicates a previous uptrend that may be losing momentum.
2. Handle Formation: After the inverted cup, the price may bounce slightly upward, creating the handle. This typically involves a small upward or sideways movement before the price drops again.
3. Breakdown: A bearish signal occurs when the price breaks below the support level formed at the bottom of the handle. This suggests further downward movement.

How does the bullish cup and handle pattern form?

The market psychology behind the bullish cup and handle pattern involves several key phases that reflect trader sentiment and behavior:

1. Initial Decline (Cup Formation): After a prior uptrend, prices start to decline as sellers gain control. This phase reflects uncertainty and profit-taking, where traders are cautious, leading to a gradual drop in prices. The decline is often influenced by external factors or changing market sentiment.
2. Bottoming Out: As the price reaches a low point, some investors begin to see value, leading to a stabilization. This stage can create a sense of anticipation as buyers start to enter the market, believing that the asset is oversold.
3. Recovery (Cup Recovery): The price begins to rise again, indicating a shift in sentiment as more buyers enter the market. This phase reflects renewed optimism, with traders expecting the previous uptrend to resume.
4. Consolidation (Handle Formation): After the recovery, prices often pull back slightly, forming the handle. This consolidation can create uncertainty, as some traders might be tempted to take profits, while others see this as a buying opportunity. The handle represents a final shakeout, where weak hands may exit, allowing stronger hands to accumulate.
5. Breakout: When the price breaks above the resistance level created by the cup’s high, it signals a strong bullish sentiment. This breakout typically attracts additional buyers and momentum traders, reinforcing the uptrend and often leading to significant price increases.

Overall, the cup and handle pattern reflects a transition from fear and uncertainty to renewed confidence and buying pressure, making it a powerful indicator for traders.

How to trade the bullish cup and handle pattern

Trading the bullish cup and handle pattern involves a series of steps to identify, confirm, and execute a trade. Here’s a step-by-step guide:

Step 1: Identify the Pattern

• Look for the Cup: Identify a “u” shaped decline followed by a rounded bottom and recovery. The sides of the cup should be relatively symmetrical, and the volume should decrease as the price forms the cup, indicating a period of accumulation. The cup should ideally take several weeks or months to form.
• Identify the Handle: After the recovery, look for a small consolidation phase (the handle i.e. small, rectangular formation that follows the cup) where the price moves sideways or slightly downward. Volume during the handle should be lower than during the cup.

Step 2: Confirm the Pattern

• Price action: The price should break above the high of the handle.
• Volume Analysis: Observe volume trends. Ideally, volume should decrease during the cup formation and increase during the handle. Look for a spike in volume at the breakout to confirm the bullish signal.
• Time Frame: Ensure the pattern is forming on a longer time frame (e.g., daily or weekly charts) for greater reliability.

Step 3: Set Entry Point

• Breakout Level: Set your entry point just above the resistance level created at the top of the cup. This is typically where the price breaks out from the handle.
• Confirmation: Wait for a close above this resistance level to confirm the breakout.

Step 4: Manage Risk

• Stop Loss: Place a stop loss slightly below the lowest point of the handle or below the breakout level. This helps protect your investment in case the trade goes against you.

Step 5: Define Targets

• Price Target: Measure the depth of the cup (from the top of the cup to the bottom) and project that distance upward from the breakout point to set your price target. In other words, you can use the height of the cup as a potential price target.
• Tip: Consider a risk-reward ratio of at least 1:2 or higher.

Step 6: Execute the Trade

• Entry: Once the breakout is confirmed, enter the trade at your predefined entry point.
• Position Sizing: Ensure your position size aligns with your risk management strategy.

Step 7: Monitor the Trade

• Watch for Volume and Price Action: Continue to monitor volume and price movement. If the price starts to show weakness or volume decreases significantly, consider adjusting your stop loss or taking profits.

Step 8: Exit Strategy

• Target Exit: Close the position when the price reaches your target level or if it shows signs of reversal before reaching it.
• Trailing Stop: Consider using a trailing stop to lock in profits if the trade continues to move in your favor.

Additional technical indicators to use

When trading the cup and handle pattern, it’s beneficial to use additional technical indicators for confirmation and to enhance your analysis. Here are some effective indicators to pair with the pattern:

Volume:

• Volume Confirmation: Look for increasing volume during the breakout above the handle. This supports the validity of the pattern and indicates strong buying interest.

Moving Averages:

• Simple Moving Average (SMA): Use the 50-day or 200-day SMA to identify the overall trend. A price above these moving averages can confirm bullish sentiment.
• Exponential Moving Average (EMA): EMAs can provide more responsive signals in trending markets.

Relative Strength Index (RSI):

• Overbought/Oversold Levels: Use RSI to determine if the stock is overbought (above 70) or oversold (below 30). A bullish cup and handle pattern with an RSI below 70 can suggest that there’s room for upward movement.

MACD (Moving Average Convergence Divergence)

• Trend Confirmation: Look for a bullish crossover (when the MACD line crosses above the signal line) around the breakout point, indicating potential upward momentum.

Bollinger Bands:

• Volatility Analysis: Monitor the bands for squeeze patterns, indicating low volatility before a potential breakout. A price break above the upper band can signal a strong bullish move.

Fibonacci Retracement:

• Support and Resistance Levels: Use Fibonacci levels to identify potential support during the handle and to set target levels for price objectives.

Stochastic Oscillator:

• Momentum Indicator: Look for the stochastic to be below 20 (oversold) during the handle formation and crossing above 20, suggesting potential upward momentum when the breakout occurs.

Average True Range (ATR):

• Volatility Measurement: Use ATR to assess market volatility and set appropriate stop-loss levels. Higher ATR values may suggest wider price movements, while lower values indicate tighter price action.

By combining these indicators with the cup and handle pattern, you can increase your chances of successful trades through better confirmation of trends and potential price movements.