There are some investors who believe in fundamental analysis – looking into a company’s earnings history and probing the general outlook of the industry and the economy before investing in a stock. The other major school of investing – technical analysis – involves predicting the price movement of a security by analysing the historical patterns of asset prices. This philosophy of investing believes that history repeats and one can make gains in the stock markets by spotting patterns that often follow the same trajectory.

Candlestick patterns are one of the most popular tools of technical analysis. They consist of longitudinal bars that are green (or light) in colour if the closing price of an asset is higher than the opening price and red (or dark) if the opposite holds true during a period of trading. Some of the most commonly occurring candlestick patterns are rising three methods, rising triangle, falling triangle, piercing line, hammer, and double bottoms.

What is the cup and handle pattern?

The cup and handle pattern is a bullish continuation pattern that indicates a strengthening of the price of a security succeeded by a breakout after which the price of the scrip shoots up. The period of consolidation is the U-shaped cup whereas the breakout is signified by the handle.

Cup and handle chart patterns are said to have been popularised by American technical analyst

William J. O’Neil through his book How to Make Money in Stocks in the late 80s. O’Neil provided an in-depth analysis and identification of the cup and handle in a few passages. He wrote that cup and handle chart patterns last, in time duration, from 7 to as many as 65 weeks (most are usually three to six months). The usual percentage correction from the absolute peak to the low point of the price pattern varies from 12% or 15% to 33%.

Cup and handle formation

1. A cup and handle formation must be preceded by a trend for it to qualify as a continuation pattern. A trader should make sure that it is a few months old but no more than that. If the cup and handle formation is too mature, it might mean that the consolidation phase is on the weaker side and hence hurt potential gains.

2. A cup with a more rounded bottom is more preferable to one with a sharper bottom. A soft U-shape indicates that the price of the security will follow a course of correction with a few weak spells around the threshold of the cup and with support from the bottom.

3. The handle should ideally form in about a week or two. It has a downward price momentum when the price could plunge below the low touched a few weeks earlier.

4. The depth of the cup should be up to 33% of the previous upward surge but no more in normal circumstances. However, in choppy markets it could go as far below as 50% and up to 66% in extreme situations.

5. Ideally, a cup and handle formation should have similar highs on either side but usually that doesn’t happen

Trading cup and handle chart patterns

– Traders should look for a breakout succeeded by a substantial rise in volumes of trade above the line of resistance.

– A price target could be set at the same distance from breakout as it is between the bottom of the cup and the breakout.

– There are two potential points of entry for a trader in the cup and handle formation. The first comes just after the breakout duration. The volume of trade often sharply rises at this juncture and indicates a good entry point.

– The second, when the price of the security hits the line of resistance again after the breakout. Traders might even consider taking a long position when the asset breaks the line of resistance of the cup and handle pattern.

– A stop target can be set at the low of the handle. It could also be increased by a multiple of two if the trader can afford to take greater risk as the gains could be bigger.

Conclusion

While cup and handle chart patterns are quite easy to spot for experienced traders, they might be elusive to a beginner trading in the stock markets. Apart from the share market, it is quite often useful in trading in the forex market too. One clear advantage of the cup and handle formation over most other candlestick charts is that it has well-defined entry and stop levels. However, these patterns take a long term to play out in the market and also need to be extensively verified by other technical indicators.