Cup and Handle Pattern: Setting Stop-Loss and Profit Targets

The cup and handle pattern is a candlestick pattern defined by William J. O'Neil, the American entrepreneur, in his 1988 classic, "How to Make Money in Stocks.”

This article explains this pattern formation and gives tips on setting stop-losses and trading profits when trading the cup and handle pattern.

Key Takeaways

• The cup and handle pattern is a bullish continuation pattern.

• The pattern forms with a rounded bottom (the cup) followed by a consolidation period (the handle).

• Set stop-loss orders slightly below the lowest point of the handle to protect against false breakouts.

• Measure the height of the cup and project it from the breakout point to set realistic profit targets.

• Combine indicators like moving averages, volume, RSI, and Bollinger Bands for a comprehensive trading strategy.

What Is the Cup and Handle Pattern?

The cup and handle pattern is a bullish continuation pattern that signals a potential upward price movement.

• A continuation pattern indicates that the current trend (bullish or bearish) will likely continue.

• The term “bullish” indicates that the price of an asset is expected to rise. Therefore, a “bullish market” is where prices are increasing.

• The term “bearish” is the opposite of “bullish” and indicates that asset prices are expected to decrease.

This pattern resembles the shape of a teacup, where the "cup" is formed after a rounded bottoming phase, and the "handle" appears as a consolidation period following the cup.

• The bottoming phase is when the price of an asset reaches its lowest point and begins to stabilize before reversing upward.

• The consolidation phase is when the asset's price moves within a narrow range, pausing before continuing its trend.

Cup and Handle Formation and Significance

The cup and handle pattern forms in several stages, each crucial to identifying and confirming the pattern.

Below are the steps for the cup and handle formation:

1. Original Bullish Trend: The pattern typically starts with an established bullish trend, where the price of an asset has been rising steadily.

2. Price Decline: After reaching a peak, the price experiences a decline, also called a “pull back,” which creates the left side of the cup.
   The downward movement reflects a temporary shift from bullish to bearish sentiment.

3. Rounded Bottom Formation: The price decline gradually slows down, reaching a low point before recovering, forming the rounded bottom of the cup.
   The rounded shape indicates a stabilization phase in which selling pressure decreases, and buyers begin to re-enter the market, gradually pushing the price up.

4. Recovery and Approach to Resistance Line: The price continues to rise, approaching the previous peak or resistance line, completing the right side of the cup.
   This recovery phase suggests that the bullish sentiment is returning.

5. Formation of the Handle: After the cup is formed, the price hits the resistance line and undergoes a slight pullback or consolidation.
   The handle usually slopes downward or moves sideways, representing a short-term pause to build momentum.

6. Breakout: The pattern is confirmed when the price breaks above the resistance line formed by previous peaks.
   This breakout signals a resumption of the original bullish trend, with the potential for significant upward movement.

Looking for these phases helps you identify the cup and handle pattern on a chart in order to include it in your trading strategies.

Cup and Handle vs. Inverse Cup and Handle

While the cup and handle pattern is bullish, there’s also an inverse version known as the inverse cup and handle pattern.

The inverse cup and handle pattern forms after a price increase within an original bearish trend, unlike the usual cup and handle within an original bullish trend.

Moreover, while the cup and handle pattern has a rounded bottom recovery and a handle consolidation or pullback, the inverse pattern has a rounded top and a handle consolidation or slight upward movement.

Additionally, the inverse cup faces downwards, and the handle slightly consolidates upward.

Moreover, these two patterns confirmation differ:

• Cup and Handle (bullish): The pattern confirms with a breakout above the resistance line, signaling the continuation of the bullish trend and potential for upward movement.

• Inverse Cup and Handle (bearish): The pattern confirms with a breakdown below the support line, signaling the continuation of the bearish trend and potential for downward movement.

What Does a Cup and Handle Pattern Tell You?

The cup and handle pattern provides you with several key insights that can guide your trading decisions:

• Market Sentiment Shift: The formation of the cup indicates a shift from bearish to bullish sentiment.
  This shift suggests that the market has found a bottom and is starting to recover, making it a good time to look for buying opportunities.

• Potential Entry Point: The handle, representing a period of consolidation or a slight pullback, offers you a chance to enter the market.
  The breakout above the handle's resistance line is a strong buy signal, indicating that the price is likely to continue rising.

• Clear Price Targets: The height of the cup can be used to project potential price targets.
  By measuring the distance from the bottom of the cup to the breakout point, you can estimate how far the price might move after the breakout, helping you set realistic profit targets.

How to Trade the Cup and Handle Pattern

Trading the cup and handle pattern effectively requires understanding its formation and key trading principles.

Cup and Handle Trading Strategy

Here’s a detailed guide on how to trade the cup and handle pattern:

1. Identify the Pattern: Ensure you accurately identified the chart's cup and handle pattern. Refer to the previous breakdown of the pattern as your reference.

2. Wait for Confirmation: The most crucial part of trading the cup and handle pattern is waiting for a confirmed breakout above the handle’s resistance line.
   This breakout indicates that the bullish trend is likely to continue.

3. Volume Confirmation: Confirm the breakout with increased trading volume.
   Higher volume during the breakout adds validity to the pattern and suggests strong buying interest.

4. Entry Point: Enter the trade when the price breaks above the resistance line of the handle. This resistance line is usually drawn at the highest point of the handle before the breakout.

5. Setting Stop-Loss Orders: Place a stop-loss order slightly below the lowest point of the handle.

6. Setting Profit Targets: Measure the distance from the bottom of the cup to the breakout point. Then, project this distance upwards from the breakout point to set a profit target.

Continuously monitor your trade and adjust your trading strategy if needed. Finally, exit the trade once the price reaches your profit target.

How to Set Stop-Loss Order on the Cup and Handle Trades?

Find the lowest price point within the handle formation to set a cup and handle stop loss.

Then, set the stop-loss order slightly below the lowest point of the handle.

This placement protects against potential false breakouts and minimizes losses if the trade does not go as planned.

How to Set Profit Targets on the Cup and Handle Trades?

Determine the distance between the lowest point of the cup and the resistance line (the top of the cup) to set a profit target for the cup and handle pattern.

Then, add this distance to the breakout point above the handle. This projected distance provides a realistic profit target based on the pattern's size.

What Indicators Work Best with the Cup and Handle Pattern?

Using indicators while trading the cup and handle pattern is crucial to maximize your trading profits.

Moving Averages

Use moving averages to confirm the trend direction.

Check if the price is above the Simple Moving Average (SMA) or Exponential Moving Average (EMA) to ensure it is in an uptrend before the cup and handle form.

The price should stay above these moving averages during the handle formation, indicating continued strength and support.

Volume Indicators

Use volume indicators, such as Volume Moving Averages and on-Balance Volume (OBV), to validate the pattern and breakout strength.

To confirm the pattern, look for high volume on the left side of the cup, decreasing in the middle, and increasing again on the right side.

During the breakout, a significant increase in volume indicates strong buying interest and validates the breakout's strength.

Relative Strength Index (RSI)

Use the RSI indicator to identify overbought or oversold conditions.

Use the RSI to avoid entering trades in overbought conditions. Before the breakout, check the RSI:

• If it is above 70, it may indicate overbought conditions, suggesting a higher risk of reversal.

• If it is below 70, it indicates a safer entry point.

Bollinger Bands

Use the Bollinger bands indicator to measure volatility.

During the cup formation, the price should touch or stay near the lower Bollinger Band, indicating it is potentially oversold and due for a reversal.

The price should move towards the middle or upper Bollinger Band as the handle forms.

A breakout above the upper band confirms the breakout's strength, signaling a strong upward movement.

Combine Indicators

You can combine these indicators for a comprehensive trading strategy:

• Use moving averages to ensure the overall trend is bullish.

• Check volume indicators to confirm the breakout is supported by strong trading activity.

• Use the RSI and MACD to ensure strong momentum and avoid overbought conditions.

• Use Bollinger Bands to assess market volatility and the breakout's potential strength.

Limitations of the Cup and Handle Pattern

The cup and handle pattern has the following limitations that you must keep in mind:

• The pattern can sometimes lead to false breakouts, causing traders to enter positions without sustained upward movement.

• Identifying the cup and handle pattern can be subjective, leading to inconsistent interpretations among traders.

• The pattern may not perform well in volatile or bearish market conditions, reducing its effectiveness.

• The pattern formation can take a long time, causing traders to miss other opportunities while they wait for it to complete.

Conclusion

The cup and handle pattern is very important and can help you enter trades at optimal times. However, you must know how to set accurate and safe stop loss and profit targets.

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FAQs

Is the Cup and Handle Pattern Bullish?

Yes, the cup and handle pattern is a bullish continuation pattern, indicating potential upward price movement.

What Are the Rules for the Cup and Handle Pattern?

Key rules include identifying a rounded cup formation, a handle consolidation, and a breakout above the handle’s resistance level.

How Reliable Is the Cup and Handle Pattern?

While generally reliable, confirming the pattern with volume and other technical indicators is essential to avoid false breakouts.

What Is the Best Time Frame for the Cup and Handle?

The cup and handle pattern can be observed on various time frames, but it’s commonly found on daily or weekly charts.

Can a Cup and Handle Pattern Fail?

Yes, like any pattern, the cup and handle can fail. To mitigate potential losses, it’s crucial to use risk management strategies such as stop-loss orders.