Last Updated on September 3, 2023
The Cup and Handle pattern is a popular technical analysis indicator that helps identify bullish continuation patterns. In this article, you’ll learn how the Cup and Handle pattern works. You’ll also find out what to do when you spot it on the chart and how to improve your odds of making profitable trades.
What is The Cup and Handle Pattern?
The Cup and Handle pattern is a technical indicator that traders use to identify whether the price of a traded security will continue its upward movement. As the name suggests, the chart pattern is shaped like a teacup with a dainty handle when looked at closely.
The pattern forms when the asset price drops slightly but then rebounds back to the level at which the fall has started. The points where the price fell and rebounded form a “u” shape, representing the cup. The formation is then followed by a small consolidation or slight pullback with a small downward drift, representing the handle.
Cup and handle patterns work on all timeframes from hourly, intraday, weekly, and even monthly charts.
Traders look for the continuation pattern’s signals in the middle of an existing trend to identify ideal buying opportunities.
Other examples of continuation patterns include pennants, bullish and bearish flags, and ascending and descending triangle patterns.
American technical analyst and trader William O’Neill popularized the Cup and Handle pattern in his book How to Make Money in Stocks.
How it Works
To better understand how the Cup and Handle pattern works, it’s important to uncover its story. The idea behind the indicator is that if the price of the asset drops but then makes its way back up, there must be strong buying momentum to back it, which can further push the price higher.
Essentially when the price falls, it indicates that the bears have overpowered the bulls, albeit temporarily. As the bearish pressure intensifies, the price drops even lower until the point where the bulls start coming in, creating the bottom curve of the cup and continuing the momentum to take the price to the previous high. This provides a prime opportunity for traders to open positions as the price begins to rise. It also helps them avoid opening short positions against the upward trend.
How to Identify a Cup and Handle Pattern
Over the years, traders have amended O’Neill’s standards for identifying a Cup and Handle pattern, but the original specifications remain relevant.
For instance, he suggested that the depth of the cup should ideally settle between 12% and 33% from the original high. This can go as high as 40%+ during periods of high volatility.
The cup shape has a stabilizing period at the bottom, where the asset price moves sideways. This is what forms the cup’s rounded bottom. Once the cup completes, there may be a 10% to 15% pullback, creating a downward price channel that resembles a handle. The handle needs to be smaller than the cup and should not pull back more than 2/3 of the cup’s height.
Cup and Handle Formation
When examining an asset’s recent price history, there are four primary stages leading up to the formation of a cup and handle pattern:
- Initial upward price movement — the price trends upwards, recording some significant gains.
- Price drop — the asset price falls, creating a downward slope but still retains a portion of the gains from the initial uptrend. This makes up the “cup” pattern on the chart.
- Renewed uptrend — the asset price recovers, climbing slightly past its original fall point before facing a short-lived resistance, causing a slight downturn just below the new high price. This makes up the “handle” pattern on the chart.
- Continuation of upwards movement — a successful breakout leads to new price highs opening up buying opportunities.
As you can see on the chart above, the Cup and Handle pattern begins after the price moves sharply upwards. The resulting selloff and subsequent retracements are then monitored closely until the uptrend resumes. As the price continues rising, it retraces again to form the ‘handle’ section, thus completing the pattern.
How to Trade The Cup and Handle Pattern
Now that you understand how Cup and Handle patterns form, here’s how you can use it to identify entry points, set stop losses, and pick a profitable exit.
Entering a Trade
Generally, traders wait for the handle to form before picking their entry points. The handle usually takes the form of a descending triangle or sideways channel. When the handle forms, traders typically monitor the price to see if it breaks above resistance. If it does, it means the price is expected to rise, which makes it a good time to enter the trade.
Keep in mind that just because there’s a clear entry signal doesn’t necessarily mean that the price will rise. It could go up a bit, drop at the next candle, or move sideways. That’s why it’s crucial to set up stop-losses before initiating your trades.
Setting a Stop-Loss
Markets are unpredictable, and sometimes the opposite of what you expect happens. Traders rely on a stop-loss order to get them out of a trade in such situations.
In a Cup and Handle pattern, traders place their stop loss below the handle’s lowest point (around the upper half of the cup pattern). This way, the stop-loss is closer to the entry point, which helps to ensure that even if the price unexpectedly drops, the position won’t suffer huge losses before the stop-loss is triggered. At the same time, placing the stop loss close to the entry point means there’s much room for the position to grow when the price rises as expected.
Picking a Profitable Exit
Knowing when to exit a position is just as important as knowing when to enter. When trading Cup and Handle patterns, the general rule of thumb is to set the exit target above the breakout point of the handle.
The idea is to measure the price points where the cup pattern forms. Take that value and add it to the price at the breakout point to get where you should ideally set your exit target. For instance, let’s say the cup forms between $80 and $77, and the price at the breakout point is $80. The exit target should be set at $83 ($3 + $80).
Advantages and Disadvantages of The Cup and Handle Pattern
There are several advantages of trading the Cup and Handle pattern.
For one, the pattern is relatively easy to identify on a chart thanks to its distinct teacup shape. Second, it is a relatively accurate and reliable bullish continuation indicator. And lastly, it can be a fairly reliable standalone signal tool, though it is always better to utilize other technical indicators for more accurate trend confirmations.
On the other hand, there are certain disadvantages to trading Cup and Handle patterns.
The main drawback is that the pattern can take a long time to form fully. This isn’t ideal since the trader would typically need to wait for the pattern to form before entering a position. Take a look at the gold chart below, for instance. The Cup and Handle pattern started shaping in 2011, and its handle didn’t fully form until late 2022.
Mistakes to Avoid When Trading The Cup and Handle Pattern
One of the biggest mistakes when trading Cup and handle patterns is not being patient enough to wait until the handle has formed. And so traders end up buying too early without confirming if the current trend will continue upwards. Remember, the handle shouldn’t pull back more than 2/3 of the cup’s height. If the price drops too close to the cup’s bottom, it may be a sign that another pullback might be around the corner.
Traders must also know how to manage their risk properly when trading the Cup and Handle pattern. Because it is generally a reliable bullish signal, it’s easy to assume that it will always produce accurate signals. However, financial markets are complex, and their respective price actions can be influenced by various factors. That is why savvy traders should always account for scenarios of uncertainty and complement the Cup and Handle indicator with other technical trading tools.
Key Takeaways
- The Cup and Handle pattern helps identify asset prices trending up in a temporary holding pattern.
- It is a bullish continuation pattern, indicating that an existing bullish trend may continue if the price breaks out of the pattern.
- Identifying a Cup and Handle pattern on a chart is relatively simple because its shape resembles a teacup with a handle.
- The cup portion of the pattern starts to form when an upward-moving price reaches resistance and then reverses to form a dip. It ends when the price reaches support and reverses direction again, this time moving up.
- The handle forms when the price experiences a short pullback and drops slightly before reaching higher support and moving up again. The handle shouldn’t pull back too close to the bottom of the cup.
- Once the Cup and Handle pattern has been completed and the price breaks out above the resistance of the handle, it’s usually a signal that the current uptrend may continue, which indicates a buy signal.
