Chart patterns can develop clever names in the stock market. For instance, the cup and handle pattern is a legitimate moniker given to a formulation that can develop on a chart over a given time frame.
While this name provides a pretty easy snap visual that investors can spot while perusing a chart, it may somewhat get in the way of the true nuts and bolts behind the pattern and the level of effectiveness it can generate. And make no mistake – the cup and handle pattern can be used as a pretty terrific indicator of positive market trends.
What is a Cup and Handle Pattern?
As the name suggests, a cup and handle pattern is a chart pattern that resembles a tea cup. Granted, it takes a little ingenuity and perhaps a little eye-squinting to see it if you’re new to the technical analysis game, but it’s there.
The pattern itself is considered a bullish continuation pattern in which an upward trend has paused and made a downward trend, but will continue going up once the pattern resumes on its way to completion. This pattern has an impressively wide range, as it can go from several months to a year. Regardless of length, however, the pattern’s shape will remain the same.
To break the pattern down even further: The pattern itself if preceded by an upward move that eventually stalls and sells off, which is the action that initiates the formation of the pattern. After the selling occurs, the stock will essentially flatten out from a trade perspective, in a fashion that won’t produce a discernable trend. The next portion of the pattern sees the stock swing upwardly toward the peak of the preceding upward line. Finally, the pattern’s “handle” forms by creating a relatively small downward move before continuing its ascent as an upward trend.
The Cup and Handle Pattern’s Components
To use the cup and handle pattern to its maximum effectiveness, savvy investors should be prepared to dig into the minutiae of the pattern to evaluate the trading signs it flashes. In this regard, it’s not only important to scrutinize the actual pattern, but also to be familiar with the roots of the pattern.
For instance, it’s critical to note the presence of an upward trend before the formation of the cup and handle. Generally speaking, the larger the prior trend is, the lower the potential for a large breakout to occur once the pattern has been wrapped up.
The reason for this is a lot of the upswing that would constitute a significant breakout will have already occurred before the pattern form, which would cause weakness to the potential post-pattern upswing. In other words, most of the trend that would put the stock on the rise has already occurred before the pattern shows up.
The way the cup forms is also crucial to the stock’s performance. Ideally, the “cup” shape the pattern forms should be a nice, round formation that’s not unlike what you’d see in a semi-circle. The reason the shape is critical has to do with the concept of consolidation within a trend, where weaker investors leave the market, and newbies and resolute types stick with the stock.
If the cup’s shape is too sharp, it’s not considered to have an actual consolidation. In this case, its status as a potential trade is weakened.
The height of the cup should also not be ignored. Traditionally, a cup and handle should fall between one-third and two-thirds the size of the prior upward movement, depending on how volatile the market is. For instance, if you’re looking at a prior trend moving from $20 and $45, you’ll want the cup’s height to be between $8 and $16. This is because the first two numbers are separated by a $25 price swing, $8 is roughly one-third of $25, and $16 is roughly two-thirds of $25. The cup’s height can also double as an initial price target once the pattern finishes and breaks out of its handle.
Speaking of the handle, this part of the pattern is extremely critical for investors to note, as it completes the pattern. Generally speaking, a handle will form due to its downward movement retracing one-third of the gain made in the cup’s right side. During this movement, a descending trendline can be formed, which in turn creates the signal of the breakout. A move by the stock that goes above this dropping trendline is a signal that the previous upward trend is ready to commence.
A more conservative breakout sign would manifest above the price point of the cup’s two peaks. This is the price where the beginning upward trend peaked and the point where the cup’s rise on the right side rose before dropping into the handle. A breakout that shows up at this point is the strongest signal the pattern gives that the previous trend is going to continue.
Volume and the Cup and Handle Pattern
As is the case with the majority of chart patterns, volume plays an enormous role in pattern confirmation and signal formulation regarding a cup and handle pattern. The biggest indicator of volume on this pattern is the breakout. The stronger the volume appears on an upward trending breakout, the more obvious the sign that the upward trend in question will continue. With this being said, savvy investors will prepare for a brief dip back to the bottom of the new trendline to test the support before resuming its upward climb. Investors shouldn’t panic when this occurs – it’s perfectly normal.
Overall, the cup and handle pattern is another fantastic tool that technical analysts can use to detect and act upon valuable gains. Obviously, this doesn’t mean that investors are guaranteed to make money by following the pattern – guarantees have never been a thing in the stock market, nor will they ever be. Still, the proper understanding of this pattern can go quite a way to help the savvy investor maximize their potential gains and minimize their potential losses. Not bad for a pattern with an apt name.