What is the Cup & Handle pattern?
The cup and handle is a bullish continuation pattern that marks a consolidation period followed by a breakout. The cup and handle chart may signal a reversal pattern that usually occurs when the price is in a long-term downtrend or a continuation pattern which occurs in an uptrend with the price rising, cup and handle formation and the rising continues.
Basics of Cup & Handle pattern
There are two main components in this pattern, as the name suggests a cup and a handle. Other than these two components there are few other basic components which are explained in detail:
- Prior Trend: It is important to establish the existence of a prior uptrend for this to be a continuation pattern because without a prior uptrend there cannot be a Cup and Handle pattern.
- Cup: The cup should be “U” shaped and resemble a bowl or rounding bottom. The softer “U” shape ensures that the cup is a consolidation pattern, with the prefect pattern having equal highs on both sides of the cup.
- Handle: After the high forms on the right side of the cup, there is a pullback that forms the handle. Sometimes this handle resembles a flag or pennant that slopes downward. The handle represents the final consolidation before the breakout and can retrace up to 1/3rd of the cup’s advance but not more.
- Cup Depth: Ideally the depth of the cup should retrace 1/3 or less of the previous advance but with volatile market or overreaction the retracement could range from 1/3 or ½, while in extreme situations this could exceed to 2/3 but not more than that.
- Volume: There should be substantial increase in volume as the breakout above the handle’s resistance.
- Target: The projected advance after breakout can be estimated by measuring the distance from the right peak of the cup to the bottom of the cup.
Interpreting the pattern
The pattern formation is started with the prior trend being bearish, followed by formation of the “U” shaped cup with the high points of the cup being approximately even followed by a handle resembling a consolidation. The pattern is completed once the price breaks the handle trendline and starts moving in the opposite direction. Volume indicators can be used to get the final confirmation.
Once the handle trendline is broken, it commonly starts to act as the support for further price downtrends and the projected price target after breaking the handle is the same as the distance between the right high of the cup and the bottom point for the cup. This price target can be considered as a rough guide along with other factors in consideration as well.
This is the one reason that Cup & Handle is favored by traders that it has the ability to help them determine the price target estimates once the pattern is completed along with making it easy for traders to place stop-loss orders.
Using the pattern to trade
The most important part of the pattern is to let the pattern complete itself and plan your trades ahead of time so that you’ll be ready once the handle trendline or the cup highs are broken.
Traders can use the pattern breakout from two different points, one as the price breaks the handle trendline and another can be taken as when the price breaks the highs formed by the cups.
The pattern can be used to trade by going long open when the breakout is observed with either of points and long close once the price is nearing the target, with stop levels often considered as the low of the handles to minimize the risk factor.
Advantages/Limitations of Cup & Handle Pattern
There are few advantages as well as limitations to the pattern, explained below:
- The advantage being that it is easy to identify for more experienced traders while difficult to identify for novice traders
- The pattern can be used for any market with any time frame, but it often requires support from other technical indicators
- It defined clear stop-loss, entry and limit levels making it favorable but it might take extensive periods to play along and complete the pattern