Analyzing Chart Patterns: Cup And Handle

The cup and handle is both a continuation and a reversal pattern. The reversal pattern marks the end of a downtrend, and shows the price transitioning into an uptrend. 

The continuation pattern occurs during an uptrend; a cup and handle forms, then the price continues its rise. 

The cup and handle is similar to a rounded bottom, except that with the cup and handle the price stalls near the breakout point and moves sideways or lower for a period of time. The U-shaped price action forms the cup, and the sideways or downside movement that follows creates the handle.

Reversal Pattern

In order for a cup and handle reversal to form, the price must first be falling. As with a rounded bottom, the price levels off and then begins to rise. Once it forms the cup, the price then must pause and either move sideways or move lower—this is the handle.

The handle usually moves in a channel, contained between two trendlines. During the handle, the price should not decline more than about 50% of the cup height. For example, if the bottom of the cup is $5, and the top of the cup is $6, the handle should form between $6 and $5.50. If the price drops more than 50% of the cup it could indicate that the selling is too strong, which means an immediate rise is less likely.

Since the price action of the handle is usually contained within a channel or between trendlines, take a long trade when the price moves up out of the channel/handle. Drawing the handle is subjective. Depending on how the trendlines are drawn, different traders will end up with different breakout points. 

Once a trade is taken, place a stop loss below the low point on the handle. This controls risk in the event the price keeps dropping instead of rallying. 

Price Target

A cup and handle reversal may indicate a long-term trend change. Long-term trends can last for years, therefore the reversal pattern doesn't have a long-term target. Typically, the longer the amount of time the cup and handle takes to form the bigger the rally that follows. 

For an estimated shorter-term target, or to establish a risk/reward for the trade, add the height of the pattern to the breakout point. This target assumes that the size of the rally within the cup will be replicated on the next rally. If indeed the long-term trend has reversed, the price should be able to reach this target, and potentially exceed it.

Continuation Pattern

The cup and handle continuation pattern has a similar setup to the reversal pattern, except the continuation patterns occurs within an uptrend. The price is moving higher, declines forming the U-shape and handle, then breaks out of the handle to the upside signaling the continuation of the uptrend.

As with the reversal pattern, the handle should not decline more than 50% of the way down the cup. Draw trendlines along the highs and lows of the prices within the handle. Enter long when the price breaks above the upper handle trendline.

Place a stop loss below the low of the handle. This controls the risk on the trade in case the price moves lower again. 

Price Target

Add the height of the cup to the breakout point on the handle. This provides an estimated target for the next advance.

As discussed in the cup and handle reversal section, uptrends can last for years. The target represents a target for the next rally, but that target could be exceeded as the long-term uptrend unfolds.

Trading Considerations

The cup and handle continuation patterns has two positive factors working for it: an already established uptrend, and the pattern is showing the price starting to rise again following a pullback. The combination of these two factors make it a more reliable pattern than the cup and handle reversal. 

The reward on both the continuation and reversal patterns outweigh the risk, since the anticipated target is the height of the pattern, or more. The risk, on the other hand, is based on the size of the handle which is smaller than half the size of the cup. This makes the pattern an ideal trading candidate, as the potential reward is at least double the risk.