Cup and Handle pattern was developed by William O Neil and was first discussed in his book “How to make money in stocks”.
Cup and Handle pattern is one of the most important chart patterns to make money in stock market.
The cup and handle occur in a small time frame like a one-minute chart, and on large time frames like daily, weekly, and monthly charts. It occurs when there is a price wave down, followed by a stabilizing period, followed by a rally of approximately equal size to the prior decline. It creates a U-shape, or a cup. The price then moves sideways or drifts downward within a channel. It forms the handle. The handle may also take the form of a triangle.
The handle needs to be smaller than the cup. The handle should not drop into the lower half of the cup and ideally should stay in the upper third. For example, if a cup forms between $99 and $100, the handle should form between $100 and $99.50, and ideally between $100 and $99.65. If the handle is too deep, erasing most of the gains of the cup, then avoid trading the pattern.
A cup and handle may be a reversal or continuation pattern. A reversal pattern occurs when the price is in a long-term downtrend, then forms a cup and handle that reverses the trend and the price starts rising. A continuation pattern occurs during an uptrend. The price is rising, forms a cup and handle, and then continues rising.
Entering a Cup and Handle Trade
Wait for a handle to form. The handle often takes the form of a sideways or descending channel or a triangle. Buy when the price breaks above the top of the channel or triangle. When the price moves out of the handle, the pattern is considered complete, and the price is expected to rise.
While price is expected to rise, that doesn't mean it will. The price could rise a little and then fall, it could move sideways, or it could fall right after entry. For this reason, a stop loss is needed.
Setting a Stop Loss
A stop loss gets a trader out of a trade if the price drops, instead of rallying, after buying a breakout from the cup and handle formation. The stop-loss serves to control risk on the trade by selling the position if the price declines enough to invalidate the pattern.
Place a stop loss below the lowest point of the handle. If the price oscillated up and down a number of times within the handle, a stop loss might also be placed below the most recent swing low.
Since the handle must occur within the upper half of the cup if the stop loss is properly placed it should not end up in the lower half of the cup formation. For example, assume a cup forms between $50 and $49.50. The stop loss should be above $49.75 because that is the half-way point of the cup. If the stop loss is below the half-way point of the cup, avoid the trade. Ideally, the stop loss should be in the upper third of the cup pattern.
By having the handle and stop loss in the upper third to half of the cup, the stop loss stays closer to the entry point, which helps improve the risk-reward ratio of the trade. The stop-loss represents the risk portion of the trade, while the target represents the reward portion.
Picking a Target or Profitable Exit
Whatever the height of the cup is, add that height to the breakout point of the handle. That figure is the target. For example, if the cup forms between $100 and $99, and the breakout point is $100, the target is $101.
Sometimes the left side of the cup is a different height than the right. Use the smaller height, and add it to the breakout point for a conservative target. Or use the larger height for an aggressive target.
A Fibonacci extension indicator may also be used. Draw the extension tool from the cup low to the high on the right of the cup, and then connect it down to the handle low. The one-level, or 100 percent, represents a conservative price target. 1.618, or 162 percent is a very aggressive target so that targets can be placed between one and 1.618.
If day trading and the target is not reached by the end of the day, close the position before the market closes for the day. A trailing stop loss may also be used to get out of a position that moves close to the target but then starts to drop again.
Traditionally, the cup has a pause or stabilizing period at the bottom of the cup, where the price moves sideways or forms a rounded bottom. It shows the price found a support level and couldn't drop below it. It helps improve the odds of the price moving higher after the breakout.
A V-bottom, where the price drops and then sharply rallies may also form a cup. Some traders like these types of cups, while others avoid them. Those that like them see the V-bottom as a sharp reversal of the downtrend, which shows buyers stepped in aggressively on the right side of the pattern. Opponents of the V-bottom argue that the price didn't stabilize before bottoming, and therefore the price may drop back to test that level. Ultimately though, if the price breaks above the handle, it signals an upside move.
If the trend is up, and and the cup and handle forms in the middle of that trend, the buy signal has the added benefit of the overall trend. In this case, look for a strong trend heading into the cup and handle. For additional confirmation, look for the bottom of the cup to align with a longer-term support level, such as a rising trendlineor moving average.
If the cup and handle forms after a downtrend, it could signal a reversal of the trend. To improve the odds of the pattern resulting in a real reversal, look for the downside price waves to get smaller heading into the cup and handle. The smaller down waves heading into the cup and handle already provide evidence that selling is tapering off, which improves the odds of an upside move if the price breaks above the handle.
Let’s understand the Cup and Handle pattern with help of examples.
1.Scenario 1: As a Continuation pattern
This is an example of Cup and Handle as a continuation pattern in Nifty which was formed in a span of about 2 years. The index witnessed breakout from the pattern along with a gap up which confirmed further strength.
The minimum target shown by a vertical blue line (distance from high to bottom of the cup) got achieved in less than a year’s time.
2.Scenario 2: As a reversal pattern
This is another example of Cup and Handle pattern as a reversal pattern which was recently formed in Dhampur Sugar.
If you look at the handle, it looks more of a Ascending triangle breakout and the stock witnessed sharp rally post breakout in a span of just 2-3 weeks. However, the minimum target is yet to be achieved in this stock which may unfold in the coming weeks.
The good thing about Cup and handle pattern is that it has a high success ratio along with a good risk reward. But you should not forget to place your stop loss and trail your SL as the price goes up.
Moreover you should closely monitor the volume as the breakouts with low volume are less likely to sustain. You may also confirm the strength of breakout based on other technical parameters.