Cup and handle pattern trading is one of the most popular strategies among technical traders and investors. If you spot it right, this price pattern could give you a competitive edge over other traders and investors in the market.
Price patterns are a cornerstone of technical analysis. They repeatedly appear in the market, generate early signals, and are relatively easy to spot. As they emerge on all timeframes and various markets, may therefore be applied by day traders, swing traders, position traders, and investors.
The cup and handle pattern is one of the most popular chart patterns that occurs regularly within the financial markets. In this article we will get into what a cup and handle pattern is, what it looks like, how to read it, and what is the market psychology behind it.
How to Trade the Cup and Handle Pattern – Quick Guide
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- Open and monitor your position.
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What is a Cup and Handle Pattern?
The Cup and Handle is a technical price pattern that generates a bullish continuation signal and is often used by traders to identify potential buying opportunities. It has a structure similar to a "u" shape with a minor downward drift, looking like a bowl or rounding bottom. It was developed by William O'Neil and introduced in his 1988 book How to Make Money in Stocks.
As the name suggests, a Cup and Handle pattern has two components:
The Cup
The cup is a U-shaped curve that starts with a short, dramatic decline in price. During the next phase, the price remains relatively steady, suggesting it is reaching a bottom. Eventually, there is a rally that essentially corresponds approximately the original drop in terms of amplitude.
The Handle
The handle is smaller and represents a lower correction that follows the cup. It indicates that price is trying to perform a consolidation, testing its support level before making the breakout. The handle should not be excessively deep or long to have a valid cup and handle pattern.
The cup and handle pattern psychology is defined by an increased bullish sentiment. The rounded bottom of the cup signals a change in direction as buyers cautiously enter the market and selling pressure diminishes. In this stage, new buyers see a buying opportunity while prior sellers are refusing to give up trade positions at lower prices. The handle, a consolidation phase, indicates that traders are taking profits and there could come a small correction or consolidation under low volumes.
Compared to other chart patterns such as double top and bottoms, head and shoulders, wedges and triangles, which can be challenging for certain traders to recognize as well, the cup and handle pattern is a little more sophisticated. While traders' interpretations regarding this price pattern may differ slightly, there are some general rules and standards for spotting and trading the cup and handle pattern.
Cup and Handle Pattern Rules
Here are some basic criteria that might help you recognize the cup and handle pattern and manage it properly:
What does a Cup and Handle Pattern look like?
The shape of the cup and handle pattern resembles a cup with a handle. The cup shape is built first, and then there is usually a modest price fall of about thirty percent from the cup's depth. Soon both the price and trading volume start to rise. Usually, traders are looking to open a position when price breaks pattern's resistance.
The rationale behind the cup and handle pattern's is that if the price attempted to decline but then recovered, there must be significant purchasing momentum for the asset’s price to keep rising. This could attract traders to open a long position, attempting to capitalize on potential downward price movement, or at least avoid opening a short position against it.
However, before opening a position, traders should also consider additional price-influencing factors like news, geopolitical concerns, market circumstances and general trends.
What is an Inverted Cup and Handle Pattern?
An inverted cup and handle pattern, also referred as reverse cup and handle pattern or upside-down cup pattern, is the opposite of its counterpart, the cup and handle pattern, and triggers a sell signal. On the chart, the cup forms a ‘n' shape rather than a 'u,' with the handle curving slightly upward.
The pattern starts with a price decline, a rally followed by a consolidation, then another decline back to where the rally began. Ideally, the handle should be less than one-third the size of the cup. The positive thing with this price pattern is that its name—inverse cup and handle or reversed cup and handle pattern—hints what you should be looking for. In a nutshell, the inverted cup and handle pattern is a flipped cup and handle.
Here is the visual representation of an inverted cup and handle pattern on a price chart:
For traders, an inverted cup and handle pattern could mean a potential short entry opportunity. However, if you spot it, don’t jump into a short position as soon as the first indications show up on the chart. Being patient and combining the pattern with other trading indicators could help you gather additional confirmations for a potential short position.
Cup and Handle Pattern vs Inverted Cup and Handle Pattern
It is essential to understand the main characteristics and the signal generated by the cup and handle patterns if you want to improve your trading strategy.
Cup and Handle
Inverted Cup and Handle Pattern
Shape Resembles a teacup with handle Resembles an inverted teacup with a handle Signal Bullish (buy signal) Bearish (sell signal) Breakout (validation) The breakout occurs at the resistance line The breakout occurs at the support line
How to trade a Cup and Handle Chart Pattern
As soon as you spot a cup and handle pattern, you can trade it using derivatives such as CFDs. Because you do not own the underlying asset when you trade derivatives, you may go both long (buy), or short (sell). This allows you to speculate on price swings, which may allow you to trade both the cup and handle and the inverted cup and handle pattern.
However, trading the Cup and Handle pattern means much more than spotting the pattern, waiting for the breakout and opening a position. Although the cup and handle pattern can be considered a complete trading strategy by itself, each trader may have a subjective perspective, different goals and risk tolerance.
1. Open a Cup and Handle Trade
Let's assume that you have spotted a cup and handle pattern, and you decided that you want to open a trade. So, when is a good time to buy? The answer is always on the chart but may depend on you.
For some traders, a good time to buy is when the price of the asset moves above the resistance level representing the horizontal line between the highs of the cup. For others, a breakout above the handle's resistance could be an optimal entry point.
In addition to the price levels, some traders also look at trade volume in the asset before entering a trade after a cup and handle pattern. Nonetheless, the volume is more relevant in the stock traders, where a spike in volume indicates the breakout which confirms the entry signal.
Remember! Although price is expected to rise after a cup and handle pattern breakout, there is no guarantee. The price may rise a bit before declining, it may continue sideways or decline immediately after opening the trade. Hence, you need to manage your risk.
2. Place a Stop Loss to Limit your Risk
Because no price pattern is ever perfect and trader’s predictions are not always accurate, a stop-loss order might be crucial to limit your risk.
When a trader enters a long position after a cup and handle pattern breakout, a stop-loss order allows him to exit the transaction if the price falls instead of rising as expected. By selling the position if the price drops to the point where the pattern is no longer valid, the stop-loss limits potential losses.
Stop levels are frequently placed using the handle's bottom point. This can be determined by a 1:2 risk-reward ratio. Some traders could also position their stop-loss below the most recent swing low if the price fluctuated multiple times within the handle.
Remember! A reasonable setup from a risk-reward point of view should involve stop-loss in the upper half, ideally in the cup pattern's upper third.
3. Set the Cup and Handle Pattern Target
For most of the traders, the height of the cup added to the handle breakout point serves as a reasonable take profit target. However, this requires a significant price movement, and it could not always be achieved. Moreover, sometimes the cup's left and right sides may have different heights.
A more prudent approach in terms of establishing the cup and handle pattern target would be to multiply the handle's height by two and add the result to the handle's breakout price. The multiplication by two also allows you to enter a trade with a 1:2 risk-reward ratio, which also makes sense from a risk and money management perspective.
Remember! You can also use a trailing-stop to exit a trade that approaches the target if you want to take the most out of it.
Cup and Handle Pattern Benefits and Limitations
The cup and handle patterns may offer various benefits to traders who are willing to add them into their technical analysis arsenal. However, similar all price patterns, they both have some limitations that traders should be aware of.
Benefits
Limitations
Easy to identify
Visually, both the cup and handle and the inverted cup and handle patterns’ shape is simple; it has the form of a teacup with a handle, or a flipped one. Hence, these are among the simpler price patterns to identify on a chart.False breakouts
False breakouts may arise when the price rises above the resistance or falls below support levels but then immediately gets back, which may result in a loss for traders that entered prematurely. So, it is crucial to validate the pattern with additional methods.Appealing risk-reward ratio
Traders can attain a favorable risk-reward ratio by placing the stop loss order below the handle's support level and establishing a take-profit target equivalent with the cup's depth.Subjective interpretation
There is room for interpretation when it comes to the cup and handle formation. A valid pattern may not be recognized as such by all traders. This may result in false signals or missed opportunities.Relevant on multiple timeframes
The pattern is suitable both for short-term and long-term strategies as it can be spotted on various timeframes, which means that it can be applied to daily, weekly, or monthly charts.Requires experience
Although the pattern is quite simple to recognize, its accurate interpretation and making effective trading decisions based on it requires knowledge and expertise for additional confirmation.
The cup and handle pattern as well as the inverted cup and handle, are highly valuable technical analysis patterns for traders who are looking for potential buying or selling opportunities in the market. Traders can manage their risk and potentially capitalize on the market's trends by identifying these patterns and the entry point during the trade.
However, just like all the other price patterns, they have a few limitations that can be somehow mitigated by taking appropriate safety measures like placing stop loss orders to minimize risks and using other indicators or techniques to confirm the buying or selling signals.
Final words
The cup and handle, as well as the reverse cup and handle patterns, are useful technical analysis methods that might help traders identify potential trading opportunities.
Traders often use these patterns to predict the possible direction of an asset’s price movement. They can be defined as complete trading strategies as they clearly indicate the entry and exit points, the stop-loss placement, and profit target. However, to fully take advantage of the opportunities in the financial markets, it is recommended to use them alongside additional technical tools.
Free resources
Before you start trading chart patterns, you should consider using the educational resources we offer like CAPEX Academy or a demo trading account. CAPEX Academy has lots of free trading courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader or make more-informed investment decisions.
Our demo account is a suitable place for you to get an intimate understanding of how trading and investing work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged securities.
Sources:
https://chartpatterns.com/
https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/technical-analysis
https://research.stlouisfed.org/wp/more/2011-001