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What is the cup and handle trading pattern, and how does it work?

What is the cup and handle trading pattern, and how does it work?
Asked by
Anna Winter time-icon4 weeks ago
1 Answer Answer Question

Justin Freeman
Answered time-icon4 weeks ago

The cup and handle pattern typically occurs on bar charts. It was discovered by William O’Neil and published in his 1988 book, How to Make Money in Stocks. This pattern resembles a U with a downward sloping handle, which inspired its name. It is considered a bullish continuation pattern because it typically forms when the price is at prior highs, and the price typically breaks higher once the pattern is completed.

Chart 1: The cup and handle pattern on the AUD/CAD daily chart

As you can see in the AUD/CAD daily chart above, a cup and handle pattern formed between 10th August 2016 and 18th October 2016. The cup part of the pattern was completed by 27th September 2016 before the price headed lower to complete the handle by 18th October.

The currency pair rallied higher for another three weeks up to 7th November. It then changed course and headed lower before the bullish pattern reversed. The pattern did not result in a massive rally as many had hoped, but a rally did occur, proving that the cup and handle pattern is still valid in today’s financial markets.

 

Trading the cup and handle pattern

One of the safest ways to trade the cup and handle pattern is by monitoring the size of the handle and the resulting breakout. In most cases, the handle should not have more than 10 candles as this could lead to a long sideways pattern that may not be profitable, especially for intraday traders.

You should only trade breakouts that are accompanied by increased buying volume and have crossed the handle’s highs, which means that the price is likely to hit new highs. For stock day traders, strong breakouts typically appear in the morning, especially following a strong gap up, or in the late afternoon when most traders have taken a break from trading.

 

A unique way to set your profit targets

Most trading books and websites tend to advise traders to set their take profit targets at a distance equal to the depth of the cup as the price is very likely to move by at least that distance after a breakout.

Chart 2: A typical profit target and exit strategy

There is nothing wrong with this strategy, except for the fact that most other traders will be using the same strategy, and the large players know this too. Therefore, in most cases, the price may reverse just a few points shy of your target.

A better way to set your profit target is to use two trend lines (a channel) to track the price action after a breakout and to close your position once price hits the upper channel, which is very likely to happen.

 

Setting your stop-loss orders

Setting a stop-loss order on your breakout trades from the cup and handle pattern ensures that you get out of the trade as the price reverses and falls once you have entered into the trade.

Ideally, your stop-loss order should be placed in the upper third of the cup; it should never be placed below the upper half of the cup.

You should avoid entering into trades where the stop-loss would have to be in the lower half of the pattern because these trades do not offer a great risk-reward ratio.

Chart 3: Setting your stop-loss order

 

Factors to consider when trading the cup and handle pattern

You should generally avoid cup and handle patterns that have a V-shaped bottom. Instead, focus on trading patterns that have a U-shaped cup as this usually provides a more reliable signal.

You should also avoid patterns where the cup is very deep because the handle typically retraces about half the cup’s depth, which could lead to an actual trend reversal.

The volume should decline as price approaches the cup’s bottom and should increase as price rallies to test the previous high, which typically indicates that there is strong momentum on the bullish side of the market.

You should also monitor the momentum with which price breaks out of the handle pattern and rallies higher; a deep handle typically needs higher momentum for a strong bullish breakout.

 

The bottom line

Most traders who are familiar with the cup and handle pattern can attest to its effectiveness, but you should remember that nothing in the markets is guaranteed. Always use a stop-loss order in your trades and try to get the best entries possible when trading this pattern.

 

 

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