The cup and handle pattern is one of my favourite chart patterns to trade. Not only is it easy to spot, but it also gives reliable trading signals. I still get excited when I saw one forming on a chart.
Want to know another great thing? Many traders aren’t even aware of its existence.
So, if you want to leapfrog the competition, I suggest you keep reading…
What is a Cup and Handle Pattern?
The cup and handle pattern is considered a bullish chart pattern in technical analysis. It was first discovered in 1988 by William O’Neil, who famously developed the CANSLIM investing method.
It gets its name from the shape it forms on a chart. In particular, the “cup” part of the formation resembles a “U” shape, while the “handle” represents a slight pullback on the right side of the cup.
When prices break out of a cup and handle pattern, they’re expected to keep rising (at least for a while). However, as with everything in technical analysis, this is not a given.
How to Spot a Cup and Handle Pattern
Cup
As you can see in the image above, the “cup” section resembles a “U” shape on the chart. This cup pattern forms in 3 stages:
- It starts with an initial downtrend in prices – representing the left side of the cup
- Following this is a period of consolidation, where prices move sideways for a period of time. This price action forms the rounding bottom of the cup and usually coincides with low trading volume
- Finally, a rally occurs after this bottoming process, which forms the right hand side of the cup
Note, prices don’t always consolidate at the bottom like this. In some cases, prices bounce back immediately, which causes the cup to have a “V” shape. You will see an example of this below.
In general, the post-bottom rally should bring prices back to the same level as the previous peak. In other words, the left and right lips of the cup should horizontally align, so that both sides of the cup are of equal height.
This is just a generalization, however, as there are some cases when the rally ends slightly above or below the previous peak – giving the cup and handle a slight tilt.
In any case, the straight line connecting both lips forms a resistance level. In turn, this defines the eventual breakout point from the cup and handle pattern.
Handle
The handle pattern forms when prices pullback from the right shoulder of the cup. This downward drift can take many shapes, such as a triangle pattern, descending channel, or a rounded bottom.
Importantly, this dip should be temporary, and retrace by no more than one third of the cup’s height. However, this is just a rule of thumb. Don’t actually get a ruler out.
As buyers return, prices rally back towards the previous resistance level, which remember, is the upper trendline of the cup. At this point, the handle pattern is complete, and you should await breakout confirmation.
This chart of Lam Research shows how the cup and handle can take different shapes.
For instance, the first cup and handle pattern shows a “V” shape cup with an ascending triangle for the handle. In contrast, the second pattern shows both a rounded cup and handle.
This screenshot is taken from MetaStock, which is a pattern recognition software designed for finding these sorts of chart patterns. TrendSpider is another great platform that uses AI algorithms to detect chart patterns. Likewise, Finviz has powerful pattern recognition screener that you can use for free.
Depth
It turns out that the depth of the cup is quite important.
As you will see below, it plays a big part in determining your expected profit target. Put simply, the deeper the cup, the higher we can expect prices to go when they eventually breakout.
Also, as mentioned, the handle should be shallower than the cup. A general ballpark is about one-third of the cup’s height. However, use common sense. It can be slightly more than this and still work. Where you should start to question things is if prices decline by more than 50% of the cup’s height.
If you think about it, a shallower handle is more bullish. It means that sellers weren’t able to drive prices down that far before buyers took over again.
Length
There’s a lot of debate about how long the cup and handle pattern should ideally take to form.
However, this is all semantics in my opinion. You don’t actually have to sit there and measure time frames.
“Oh this person said it takes a minimum of 7 weeks, but it’s only been 5. Better not trade it.”
No. You don’t need to be this clinical.
From my experience, cup and handle patterns work on most time frames. Personally, however, I like to see them forming over 2-6 months, because it gives me the medium-term signals I like to trade.
Really, the only rule worth following is that the cup should take longer to form than the handle. So, if the cup took 8 weeks to form, the handle formation should take no longer than this.
How to Trade the Cup and Handle Pattern
Entry
As you can see in the diagram above, the best place to enter a long position is just above the right shoulder of the handle.
This represents the breakout point from the cup and handle’s resistance line – which connects all 3 peaks.
To mitigate the risk of a false breakout, you should look to see if there’s increased volume before the breakout and set a stop loss just below the resistance level.
Exit
After the breakout occurs, the minimum price target is calculated through the following steps:
- Measure the height of the cup from its lowest point to the resistance level
- Add this vertical distance to the handle patterns breakout point
The red lines in the chart below show this process in action.
As you can see, this provided the perfect exit level in the first cup and handle pattern. However, it got you out slightly early in the second.
This shouldn’t come as a surprise though. There is no exact science with technical analysis. You will rarely call the top or bottom precisely, so don’t fret if you end up missing some gains.
All this does is provide you with a framework to stay disciplined.
And… at the end of the day, nobody ever became poor taking profits.
Inverse Cup and Handle Pattern
The inverse, or inverted, cup and handle pattern shares exactly the same logic as the standard cup and handle pattern, but in reverse.
This makes it a bearish pattern instead of a bullish one, that’s useful for timing exit points of long positions, or entry points for short positions.
Optically, this looks like an upside down version of the standard cup and handle pattern. Instead of a “U” shape, the cup resembles a dome. And instead of a slight downdrift, the handle resembles a slight updrift.
In addition, the line connecting the cup and handle at their base is no longer a resistance line, but a support line. When prices break through this, it signals the beginning of a new downtrend.
This chart shows 2 instances of an inverted cup and handle pattern. In the 1st instance, the cup and handle are both rounded domes. In the second instance, however, the cup looks like a pointed mountain while the handle resembles an ascending channel.
In both cases though, the subsequent trend was bearish following the breakout.
Now, the astute amongst you will notice that in the 2nd pattern, prices briefly dipped back above the support line after the breakout occurred.
Therefore, if you entered a short position at the breakout and set a stop loss just above the support line (as suggested earlier), you would have missed out on the subsequent decline. Unfortunately, this is what happens in trading sometimes.
Is the Cup and Handle a Bullish Continuation Pattern?
The cup and handle pattern can either be a bullish continuation pattern or a reversal pattern. The way to tell is by looking at direction of the prior trend.
If there was a prior advance leading up to the cup and handle formation, then it’s a continuation pattern. However, if a decline precedes it, it’s a reversal pattern.
The following chart shows a bullish continuation pattern. As you can see, the trend leading up to the cup and handle pattern was a bullish one. In a bullish trend, the cup and handle represents a consolidation phase, where prices level off for a while. However, once the price breaks through the resistance line, the previous bullish trend continues.
In contrast, a reversal pattern occurs when the previous trend is bearish.
As you can see in this chart, the cup and handle pattern provided the perfect reversal signal for timing Caterpillar’s bottom in 2009.
What is the Cup and Handle Pattern Success Rate?
While there isn’t an exact success rate for the cup and handle pattern, it is generally considered to be one of the most reliable chart patterns. In other words, it has a higher success rate compared to most others.
The head & shoulders pattern shares is similarly reliable, however there are still rare occasions when you come across a failed head and shoulders.
The success rate is determined by a few things:
- The higher the volume is towards the handle breakout, the greater the likelihood for a sustained move upwards
- It tends to work better in bull markets than bear markets
- The shallower the handle, the greater the chance of a breakout