Cup and Handle Pattern: Trade Like a Pro

Summary:

A “cup and handle” pattern is a specific chart pattern that reveals the market conditions to those that can interpret it. In this blog, we are unravelling its secrets and giving you a peek into the world of market charts. Read on to know more.  

Have you ever traded in a cup and handle pattern? If you have, then you know that it isn’t as easy as it looks. Your mind might have been racing with questions such as:

Can I be certain that this is a cup and handle pattern?

Where should I place my stop loss order?

Should I trade the breakout of the cup and handle pattern or wait for a pullback?

If you have faced these and any other issues, look no further. In this article you’ll have the answers to all your questions and more.

How to recognise a cup and handle pattern?

As the name suggests, a “cup and handle” pattern resembles a teacup. The term was made popular by William J. O’Neil in the first edition of his 1988 book, ‘How to Make Money in Stocks’. The pattern consists of two distinct components:

1. the cup that has a distinctive U-shape - formed when the market is in correction or profit taking sets in leading to the downward trend.
2. the handle that moves slightly downward – formed when a stock comes out of the right side of the cup and tries to reach new high prices during an uptrend and faces resistance.

While identifying a cup and handle pattern, it is important to consider the following:

• Timeframe: The cup and handle pattern can occur on daily, weekly, or monthly charts.
• Market scenario: Cup and handle patterns tend to be less favourable trades when the overall market is experiencing a downturn or a bearish phase. It can indicate either a reversal or a continuation pattern.
• Length: Look for a longer curve. The more U- shaped the bottom is, the stronger the signals are. Avoid curves that are in the shape of a “V”.
• Depth: Avoid pattern trading in cups and handles that are too deep as this negates the profitability of the cup. The handle should be smaller and not go lower than the top half of the cup. 
• Volume: This pattern is more likely to succeed if the breakout from the handle's high occurs with trading volume higher than the 10-day average volume

How to trade using the cup and handle strategy

There are many approaches in trading the cup and handle pattern. Below are best practices to keep in mind:

• Resistance Level: You should trade when the stock breaks the resistance with increased trading volume and continues to rise.
• Potential entry point: The most basic approach is to enter with a bullish attitude and buy when the price crosses the top of the triangle of the handle. 
• Target 1: For short-term trades, the initial target is the price range within the handle. You're looking for the price to move up by the same amount it dropped from the top to the bottom of that handle.
• Target 2: The next target depends on the cup's size, specifically the price-range from the top of the cup to its bottom. For instance, if the price at the top of the cup is at ₹1000 and the lower edge is at ₹700, that's a drop of ₹300. Following the breakout, ideally, you'd want the stock to increase by ₹300, taking it from ₹1000 to ₹1300. 
• Stop loss order: To manage risk, it's advisable to set a stop loss at approximately 7% to 10% below the entry price. Consider allocating 10% to 15% of your trading capital to this position. For the price target, aim for a gain between 20% to 30%, but keep in mind that prices can surpass these levels or retreat - which is why a stop loss is necessary.
• Volume Increase: Observe how the volume spikes when the stock breaks the handle formation. The volume increases again when the stock breaks the cup and handle resistance.

An example of trading a cup and handle pattern

The image above shows a beautiful cup and handle pattern

• If you look closely at the image, you can see the breakout above the handle was backed by good volume. Buying at this rate (₹76 approx.) is a good bet.
• You can place the stop loss at around ₹ 68.
• Your second transaction should take place when the resistance pattern is broken on the upside. Looking at the chart, the predicted price could be placed between ₹ 80 - ₹ 82 and backed with good volume. 
• From here, you can keep a trailing stop loss order and continue to hold the stock.
• In the image you can see that after hitting the first target, the stock continues upward in the same range.
• If it breaks the range in the future and descends, you can keep the low of the range as a stop loss.

In conclusion

Before trading, always ensure that the stock is in an uptrend and use other indicators to mitigate loss. If you are unsure about the basics and concepts, make sure to consult a financial advisor for best results