The Cup & Handle pattern on a chart is a widely used pattern analyzed by traders everyday. The pattern gets its name from a large dip on a chart in a formation that bears a resemblance to the letter “U” where the top of the far right side of the “U” has a slight decrease in price action forming a “handle”.
This pattern indicates that a stock was trending upward for sometime and then saw a slow and steady decrease in price where it then leveled out and traded within a channel for a small period of time. Once it leaves this channel it has a slow and steady uptrend where it then forms a handle, where we see the price decrease for a short period of time and then the uptrend spike occurs.
Describing this trading pattern in words can sometimes be difficult to understand. You can see in the image below where the cup is formed and how the handle completes the pattern.
It's important to understand why a pattern is formed in the first place and why it’s relevant to the stock you’re trading or hoping to trade. Usually the Cup and Handle formation appears on a chart when buyers have pushed the price of the stock high enough to sway some sellers to take profits. Once these sellers begin taking profits the price of the stock dips back down to a previous trading level where it forms a channel. In that channel we may see the price fluctuate within a tight range. Sometimes this can be a few cents or a few dollars but the important thing to know is on a chart the movement won’t be high high’s and low low’s.
During this period, if a trader can catch the pattern early enough, these can be great swing trading opportunities. Hindsight is 20-20 though and it’s important to know that if the cup isn’t formed properly this channel will break and the price could trend downward.
Once the cup has been completely formed it means that the sellers are starting to back off and the buyers are gaining control which pushes the price upwards again. This causes sellers, who may have missed out on this same price before, to start selling again. However, the handle is formed when there are more buyers then sellers and thus the price beings to increase a little more faster than before.
It’s important that if you are going to trade the Cup and Handle pattern that you are able to properly recognize a good cup versus a bad cup. When looking at the pattern you want to be cautious of the downtrend into the cup formation. If your stock decreases rapidly and then increases again rapidly it will form a “V” instead of a “U” and that can be a riskier trade as it may just indicate a sudden spike in the price action. What we want to see is the price gradually level itself into that trading channel and then a slow increase in the price trending upwards.
Here is what a good Cup and Handle pattern looks like on a chart:
As you can see in the image above there are many small cup and handle patterns forming but they are aren’t producing great results in the short term trading window. However, we finally get a solid Cup that forms a handle followed with an upward trend in the price.
Here is what a bad pattern looks like:
In the image above you can see where a cup and handle formed and then failed to breakout. This can deceive many traders into believing that a bullish period is about to happen. There is no way to predict this occurrence using just the Cup and Handle pattern. With a tight stop loss this would have taken a small loss but overall would have protected the trader from an even bigger loss or possible bag holding.
We can also see a risky Cup and Handle formation. It’s almost questionable. We see a wide cup with a tiny handle. It’s hard to trade right there because we don’t know if this is still in the middle of the dip or if its the beginning of an uptrend. In situations like this its better to sit back and just watch from the sidelines.
The second risky play shown here is the “Higher Highs” where the stock is currently trading at. Buyers need to be cautious loading up here even if the Cup and Handle pattern looks good because sellers who have been in the stock a while may be looking to sell off for profit. Also, there was a large spike of gains happening just before this reversal. A lot of sellers may take this opportunity to exit the stock and be happy with the profits they have without risking anything else.
It’s highly advisable that you never trade off just one pattern or indicator alone. Ideally, a trader should be using the Cup and Handle pattern along with an array of other indicators and patterns to help confirm a positive uptrend in the stock. While it’s possible to buy in on that initial dip using multiple other indicators the best “buy-in” for Cup and Handle pattern is just above the breakout level on the handle. That way when we look at a chart and we see the large “U” we can be ready if a slight reversal occurs to form the handle. This would allow the trader to capture the right price just before the uptrend occurs.
Remember, nothing is guaranteed in trading. A perfect formation can form and then suddenly disappear at any moment. It’s important to do your own due diligence and ensure there isn’t any upcoming news/catalyst that could affect the price action in a negative way. Always use a stop loss and protect yourself from taking major losses. You only want to risk 2% of your trading account. Be consistent and know when to exit.
All Stock Charts were gathered for educational purposes from Tradingview.com
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.