- September 1, 2020
- Posted by: CoachShane
- Category: Trading Article
The cup and handle chart pattern can be a continuation pattern or can mark the turn in trend from a downtrend to an up trending market. This would make it a reversal pattern.
Why is this chart pattern called a “cup and handle”?
- Price forms a U shape pattern that resembles a rounding bottom of a cup (yes, this is subjective)
- Price makes a high, the pullback that occurs and then begins to move upwards forming a handle of the cup
Virtually every chart pattern is subjective so do not look for exacts. If it doesn’t stand out to you, then it is not there.
Chart patterns such as the cup and handle, a form of technical analysis, can give you indications on where to enter the trade, where your stop loss should go, and even take profit levels.
I am going to cover how to trade the cup and handle pattern in 6 steps below.
How To Recognize The Cup and Handle Pattern
This pattern is not time dependent and there may be an edge in using them on higher time frame charts.
We can find the cup and handle pattern at two locations:
- If the market is in a downtrend, look for price to make a rounding transition and start moving upwards
- Since this is a bullish chart pattern, if are market is in an uptrend, look for a move down in price
There are many ways to define a trend including moving averages and higher highs and lows/lower highs and low.
This is a daily stock chart but cup and handles can be found in any instrument and any time frame.
- Price is in an overall uptrend
- Price has pulled back after a gap up and strong momentum in the stock.
As price forms the rounded bottom, hopefully at an obvious support level, the overbought condition of the move up, is worked off. Price begins to move in the direction of the prior uptrend and the cup and handle formation begins.
As price moves moves lower and then higher, it forms the sides of the cup and eventually meets up with the previous pivot high that forms potential resistance.
When and if price stalls at this level, we call it the peak of the cup and now we want to see the handle form. The handle of the cup as seen on the right can also be considered a bull flag or a trading range and traders can trade that pattern.
What we don’t want to see is the handle portion pull back too deep into the distance of the right side of the cup.
If price was to pullback over 33% of the height of the sides of the cup, we would void this as a cup and handle. We want to see sustained strength or lack of weakness as price sits at the peak of the cup. Price falling too deep will demoralize the buyers and the edge in the pattern would be gone.
Essentially, we want strength into the cup and handle pattern breakout and deep pullbacks can negate that.
Cup And Handle Trading Strategy – Now What?
The cup forms as price hits up against resistance and the handle forms as price pulls back from that level. Now what do we do?
We need a trading setup, a place to enter the market, and we have rules we can now use to enable us to take advantage of this bullish pattern.
There is an aggressive entry and a more conservative trade entry that can be used.
Aggressive Trade Entry
This entry point will front run the completion of the pattern so be aware of the risks involved.
We can use any entry technique that would be same as trading any pullback pattern and for this example, we will use the same chart as above.
Using an upper trendline and mirroring on the bottom of price, we can capture the rhythm of the pullback. It is also can give us an early entry as price breaches the low of the channel and is bought back up.
This is a form of a failure test trade but we are using it as an entry technique into a pullback that forms the handle of the cup and handle price pattern. We would look to place our entry order over highs and get taken into the trade on any upside move.
Conservative Entry – Breakout of Handle
Waiting for a breakout of the handle will complete this chart patterns entry point. What you need to do is decide what a valid breakout is.
- Do you need the additional confirmation of increased volume (If so, will you trade Forex?)
- Do you need to see a strong candlestick close?
- Will you just buy stop the upper channel and let the odds play out?
This chart shows a less than picture perfect cup and handle formation but you should know that at times, you will need to use discretion.
The conservative entry involves placing a stop buy order slightly above the upper trend line of the handle.. Keep in mind that price did dip deeper into the pattern but you can see price rejection. Would you still take the trade?
That pattern has failed after the breakout and while some would expand the channel lines thinking a complex pullback is forming, price has already hit too low in the pattern.
Where Does Your Stop Loss Go?
Setting the stop loss is fairly simple on this pattern. In both the conservative and aggressive entry, I would use below the low of the price channel with some wiggle room. Some traders may decide to use the average true range to read volatility and use that for their stop loss.
Regardless of the placement, ensure that stops are taken without question if price reaches them.
Also, do not get caught up in the “lower risk trade” mentality. There is no such thing if you are using a percentage of your account to determine your loss size. That will then translate to the number of shares, contracts or lot sizes you can buy.
If your stop loss is hitting below the half way point of the price pattern, you may decide to scratch the trade as your take profit levels may be too far from the entry price. Let’s cover that in the next section
Cup And Handle Profits and Trade Management Areas
Common wisdom with these patterns is to take the depth of the cup portion of the pattern and project that from the entry price level.
There are a few issues we need to address when it comes to price targets and trade management areas.
Our ultimate price target is the measuring the distance from the bottom of the of cup to the top and projected from our entry area.
In this example:
- Entry is at break of high of candle that tested lows and was rejected
- Stop location is 2 times the ATR rounded to $10
- Our ultimate price target is the depth of cup projected from entry – Increase of $66 per share for a 5:1 reward risk ratio
We have an issue just above our entry called potential resistance.
If this pattern will fail, the opportunity is either at the handle formation or at resistance. This is no different than the standard pullback trade and here, we are looking to profit from a breakout of resistance – the peak of the cup.
From a trade management perspective, I would consider taking partial profits at the potential resistance level where price could fail or at least be on alert for the failure. The ability to do that will depend on your position size.
However, before price broke from the upper channel of the handle, price had already move 1R so scaling out and banking some profit (and reducing overall risk %) is a smart play. This way, if price does fail at resistance, we will still take some profit and probably scratch on the other position.
This is the advantage of an early entry.
For the breakout of the handle, I need price to break resistance before hitting 1R. You need to define how you will enter these trade.
Traders may also choose a trailing stop method to keep their profits running. There are many ways to trail your stop such as ATR and using a moving average.
6 Cup And Handle Pattern Rules You Should Learn
Let’s cover something that you should consider: what the cup and handle pattern in easier terms.
Quite simply, we are trading a pullback in an up trend and banking on a breakout trade. The pullback will give us an early entry into the breakout of resistance. Keep that in mind.
- Look for a market that is reversing in a saucer like formation. It can be from a down trend transitioning to an uptrend or an up trend already in play
- Price forms the right side of the cup as price travels to resistance
- Look for some type of consolidation of price – pullbacks and ranges are simple to spot
- Enter either during the pullback or when price completes the handle part of the pattern
- Project profit target from depth of cup from entry
- Manage trade paying attention to the resistance that formed as the cup completed.
I don’t get caught up in the different chart patterns because as you can see, the cup and handle pattern is just other patterns combined.
You can download a PDF I put together called Price Pattern Trading which will guide you through trading simple patterns that have an actual edge in the market.