Last Updated on 13 January, 2021 by Samuelsson
Chart patterns occur when the price movement on the chart forms a recognizable shape, such as a triangle, rectangle, flag, or — in this case — a cup with a handle. These recognizable patterns tell a story about price history and offer a visual way to trade, giving bullish or bearish signals. But where does the Cup and Handle pattern fall into, and what does it even mean?
A Cup and Handle pattern is a chart pattern that takes the shape of a cup with a handle. It is a trend continuation chart pattern and can be bullish or bearish, depending on the trend where it is formed. In an uptrend, it is bullish, while in a downtrend, it is bearish.
In this post, we will explore the Cup and Handle pattern, its structure and types, its significance, how to trade it, and the limitations.
What are the Cup and Handle chart patterns?
A Cup and Handle pattern is a pattern of price movement on the trading chart that resembles a cup with a handle, from where it derives its name. The cup section of the pattern is formed by a u-shaped price movement, while the handle is a short price channel from the edge of the cup. The handle is actually a pullback after the right swing of the cup.
As with other chart patterns, the Cup and Handle pattern shows you how the price has moved in the immediate past, which can help you to predict future price movements. The time it takes the pattern to form varies: the pattern’s formation may be as short as seven weeks or as long as 65 weeks or more.
The pattern is of two types: the more popular bullish Cup and Handle pattern that you may see in a bull market and the inverted Cup and Handle pattern, also known as the bearish Cup and Handle pattern, which you may see in a bear market. In the bullish type, which occurs in an uptrend, the pattern is formed by a downswing (pullback) that gradually turns to an upswing (in the trend direction) and then followed by a small pullback (a slight downward drift that forms the handle). The inverse/bearish type, which appears in a downtrend, is formed by an upswing (pullback) that gradually turns to a downswing to continue the downtrend, but then, slightly pulls back again (the handle).
While some patterns may have a well-rounded bottom/top, like a bowl/dome, others just make a slight turn at the bottom/top, as the case the makes. The longer and rounder the bottom/top, the stronger the signal. A V-shaped bottom/top is not usually considered a good Cup and Handle pattern.
Just like in other chart patterns, the Cup and Handle pattern provides a logical entry point, a stop-loss level, and a profit target. You can add this pattern to your trading arsenal to improve your market analysis and trading skills.
Understanding the structure of the Cup and Handle pattern and the inverse
The Cup and Handle pattern can form in any timeframe, but as a swing trader, you should focus on the daily timeframe. To identify the Cup and Handle pattern or the inverse type, you need to understand the price movements that form its structure. For example, being a continuation pattern, there has to be a prior trend before the Cup and Handle pattern forms. Let’s take a look at both patterns one after the other.
The bullish Cup and Handle pattern
Here are the features of a bullish Cup and Handle pattern:
- An uptrend: For a bullish Cup and Handle pattern to form, there must be an established uptrend, but the trend should not be too mature as the more mature the trend is, the less likely it would continue. A trend on the daily timeframe that is a few months old is fine.
- The cup: The cup is formed by a normal pullback that gradually turns upward, forming a “U” shape. It should have a bowl or rounding bottom and not a sharp “V” shaped bottom. A rounding bottom ensures that the cup is a consolidation pattern with valid support at the bottom of the “U”. Also, the pattern should have equal highs on both sides of the cup, but that may not always be the case.
- Cup depth: The cup should not be too deep. Usually, the depth of the cup should be about 38.2% Fibonacci retracement of the previous advance. However, in more volatile markets with over-reactions, the retracement could range from 38.3% to 50% Fibonacci. In extreme situations, the retracement could be up to 61.8% Fibonacci, which is in line with the Dow Theory.
- The handle: This is a pullback that forms after the high forms on the right side of the cup. It is a short pullback or consolidation that sometimes resembles a flag or pennant that slopes downward. It is just a small, final consolidation/pullback before the big breakout but can retrace up to 38.2% Fibonacci of the cup’s swing up. The smaller the retracement, the more bullish the formation and the more significant the breakout.
- Duration: While the cup can extend from 1 to 6 months (or many years on weekly charts), the handle may take about 1-4 weeks to form.
The bearish/inverse Cup and Handle pattern
The features of an inverse Cup and Handle pattern are as follows:
- A downtrend (bear market): There must be an established downtrend for the inverted Cup and Handle pattern to be meaningful. However, the trend should be relatively young as downtrends don’t last that much. On the daily timeframe, the trend should be from a few weeks to a few months.
- The dome (inverted cup): The dome of this pattern is formed by a normal price rally in a downtrend (pullback), which gradually turns to a downward swing, thereby forming a dome shape. It should have a rounding top and not a sharp pyramid top. A rounding top ensures that the inverted cup is a consolidation pattern with valid resistance at the top of the structure. Both sides of the dome may or may not have equal lows.
- Dome height: The dome should not be too high. Usually, the height should be about 38.2% Fibonacci retracement of the preceding downswing, but the retracement could range from 38.3% to 50% Fibonacci in more volatile markets with over-reactions. In extreme situations, it could be up to 61.8% Fibonacci.
- The handle: This is a slight pullback that follows the downswing that forms the right side of the dome. It is a small consolidation that often looks like a bearish flag or pennant that slopes upward. The handle can retrace up to 38.2% Fibonacci of the dome’s swing down, but the smaller the retracement, the more bearish the formation and the more significant the breakout.
- Duration: The dome may take about 4 to 6 weeks or more to form, while the handle may take about a week or two.
What the Cup and Handle pattern tells you about the market
Both the Cup and Handle pattern and the inverse type tell a similar story about the market but from different perspectives (directions). So, we will discuss the Cup and Handle pattern; the opposite applies to the inverse pattern.
The Cup and Handle pattern form when, in a nicely rising bull market, the price tests an old high and encounters selling pressure from profit taking. The selloff is not usually so steep because it is coming mostly from profit taking; hence, the price gradually declines and consolidates over a period of time. Previous buyers, as well as new ones, see the pullback as an opportunity to accumulate positions in the market, leading to a gradual ascent to retest the high from where the pullback initially started. The price is briefly rejected and takes a little more time to build up strength before taking out the high. The more the consolidation, the bigger the breakout. A Cup and Handle is considered a bullish continuation pattern and is used to identify buying opportunities.
Almost the exact opposite happens in the inverse Cup and Handle pattern, which occurs in a downtrend and is considered a bearish continuation pattern by those who like to go short on the market. In both patterns, volume data can be very helpful. Volume should decrease during the formation of the pattern, but there should be a spike when the breakout/breakdown happens after the handle formation.
How to trade the Cup and Handle chart pattern
The Cup and Handle pattern and the inverse type are potent trend continuation signals. When you see any of them, you have to trade in the direction of the trend. While you can trade these price action chart patterns on their own, it may be wise to confirm the trend with some tools, like trend lines and moving averages.
Trading the bullish Cup and Handle pattern
The bullish Cup and Handle pattern forms in an uptrend and gives a bullish breakout signal. You might have to fix an uptrend line or a moving average to confirm the trend. Here is how you trade the pattern:
With this pattern, a buy signal occurs when the price breaks out of the upper trend line of the price channel that forms the handle. There should be a substantial increase in volume on the breakout above the handle’s resistance. Go long at the close of the breakout candlestick. Alternatively, you place a stop buy order slightly above that upper trend line. Sometimes, it is prudent to wait for a breakout above the resistance line established by the highs of the cup.
You need a stop-loss order to get you out of the trade if after buying the breakout, the price drops, instead of rising. Your stop loss should be at a level that invalidates the pattern’s signal, and that level is below the lowest point of the handle.
There are two potential profit target levels for this pattern. The first profit target is estimated by measuring a distance equivalent to the size of the handle, starting from the breakout point. The second profit target is estimated by measuring a distance equal to the depth of the cup, again, starting from the point of the breakout.
Trading the bearish Cup and Handle pattern
The bearish Cup and Handle pattern forms in a downtrend and is traded as a bearish breakdown signal. So, you can use it to go short on the market if you want. This is how you trade the pattern:
You have a sell signal when the price breaks below the lower trend line of the price channel that forms the handle. There should be a spike in volume when this breakdown happens. You may go short at the close of the breakdown candlestick, or you place a stop sell order slightly below that lower trend line. It might be wise to wait for a break below the support line established by the lows of the inverted cup.
When you are trading the inverse Cup and Handle pattern, you should place your stop loss order above the highest point of the handle.
Two potential levels are good for your profit target: the first profit level is estimated by measuring a distance equal to the size of the handle, starting from the breakdown point, while the second profit level is estimated by measuring a distance equal to the height of the dome (inverted cup), starting from the point of the breakdown.
Drawbacks of the Cup and Handle
As with all technical analysis setups, the Cup and Handle pattern has some limitations. One of them is that it can take some time for the pattern to fully form and the duration is not known beforehand, which may affect the trader’s plan and can lead to late decisions. The pattern typically takes 1-6 months (or even years) to form, but it can also happen quite quickly or take much longer, making it ambiguous in some cases.
Another issue is the depth of the cup part of the formation. A shallower cup can be a signal, while a deep cup can produce a false signal. But how deep is deep? There is also the issue of the handle: is it necessary for a setup to be valid? Sometimes, the cup forms without the characteristic handle.
Finally, just like in many technical patterns, the Cup and Handle pattern can be unreliable in illiquid markets. To get the best out of the pattern, you may have to combine it with other technical analysis tools.
Always test the strategies you’re going to trade before you put any real money on the line. There are so many traders that lose most of their money, simply because they didn’t validate their strategies. We’ve mentioned it several times, but our guide to backtesting and how to build a trading strategy are excellent resources that will help combat this issue.