Reading stock charts is a great skill for a novice investor to develop. Understanding handle and cup patterns, ascending triangles, double bottoms, and a variety of other shapes related to the stock market can help you decide when to buy into positions that will yield the most profit. Simply buying into a growth stock that’s had a reliable upward trend for a few months isn’t necessarily a good idea.
All companies experience cycles of growth and decline. The key to buying shares is to get in at a point at which you’re confident the company’s here to stay.
Stock chart patterns are extremely helpful in finding that point. Experts have named a few of these patterns as being especially beneficial for investors, such as pennants, triangles, and heads and shoulders.
But one pattern has proven to be remarkably reliable for those looking to profit with stock: cup and handle.
What is cup and handle in stocks? In this post, we’ll examine stocks with cup and handle patterns, how to recognize them, and what buy point will reap the most rewards.
What Is Cup and Handle in Stocks?
The cup and handle stock chart was introduced in 1988 when entrepreneur William J. O’Neil wrote about the concept in his landmark book How to Make Money in Stocks: A Winning System in Good Times and Bad. The teacup trading pattern has since become a reliable bellwether for finding growth stocks on the cusp of maturity.
In a cup and handle stock chart, a commodity reaches a certain high price point after an upward trend. It then begins a gradual overall decline until it reaches a low point and slowly works its way back up. When the share price meets its earlier high, this segment of the stock chart looks like a cup or bowl viewed from the side.
The next part is what you really have to watch for. After the second high point, the stock price goes into a decline, but not one as dramatic as the left-hand side of the cup. This decline also takes place during a shorter time, so when it’s viewed at a distance, the pattern looks like a cup handle.
When the share price rebounds for a second time, the handle is complete. Most investors believe this is the point to enter into a long position on the stock. The thinking is that the company has established itself and is in a position for continued, long-term growth.
A Closer Look at Stocks With Cup and Handle Patterns
What does a cup and handle actually mean in stocks? Let’s take a closer look at the elements and discuss which tea cup trading patterns are legitimate opportunities (and which ones aren’t).
The Cup
The beginning of the cup represents the culmination of an upward trend. Optimally, the share price should reflect gains of around 30% over one to three months. This means the market has rallied around the commodity and pushed it to new highs. But it also exposes the share price to a potential correction trend. That’s when it’s time to start watching.
During the pullback, shareholders begin exiting from their positions. When the share price experiences a decline of around 38% to 50%, investors who may have been eyeing the stock for a while buy in, expecting the price to rebound to its earlier high.
And as momentum builds and more investors take positions, that’s exactly what it does. The cup is complete.
The Handle
At this point, some investors — especially those who do a lot of short-selling — figure the stock has hit its resistance level and decide to sell in bunches. But this pullback doesn’t go nearly as deep or as long as it does in the cup. The drop-off from the share’s second high price should only be around 8% to 12%.
This slight downward trend will continue for a while. Short-selling investors feel they’ve already cashed in as much as they can, while long-term investors feel more confident and wait out the sell-off.
When the resistance is over, the stock begins another upward trend and the handle is more or less complete. Conventional wisdom says this is the point where new investors should hop on board and take long positions on the stock.
Traits to Look for in a Stock Cup and Handle
A cup and handle pattern can take as long as 65 weeks to develop, or it can appear as quickly as seven weeks. Recognizing when it starts can be a little tricky. Here are a few guidelines to help.
Look for Solid Gains Before the Cup
The initial uptrend — the one that precedes the formation of the cup — should be at least a few months old. It also shouldn’t be too high. If it is, there’s far less of a chance of the pattern persisting.
Look for U-Shaped Cups
Start watching the stock when the cup appears to be forming and the downward correction ensues. A proper cup should resemble the shape of the letter “U,” as it shows that resistance is not too strong — some investors are still convinced that the company’s fundamentals are too sound to cash out.
“V” Is for Volatility
Avoid cups with V-shaped bottoms. These show that the commodities in question are reversing quickly. Something’s making investors too jittery to trust the company over the long haul. U-shaped bottoms show underlying confidence in the stock.
How Deep Is Your Cup?
The first pullback phase of the cup should indicate a decline in value by about 1/3 of the high or around 30%. In volatile market conditions, emotional investors taking part in the sell-off may drive this price down by as much as 1/2, or even 2/3 if they’re really skittish. In any event, you’re waiting this storm out.
How to Handle the Handle
The handle that forms after the cup is complete should be a pullback of no more than 1/3 — optimally, between 8% and 12%. The more modest the sell-off, the more bullish the outlook on the stock. Investors should look for a point when the share price is right around the resistance line established by the second high.
As a rule of thumb, this is the point to enter into a cup and handle stock. It’s where the big breakout is expected to start.
Big Cup, Short Handle
Timing is everything with the cup and handle pattern. It can take anywhere from one to six months for a proper cup to form, so prepare to be patient.
The handle, on the other hand, can span between one to four weeks. There’s just enough resistance coming from the short-sellers during this time to drive the price down, but the relative modesty of this drop shows that there’s still solid support. Give the handle at least five trading days to develop.
Keep the Handle High
Make sure the handle is entirely contained in the higher part of the chart — but also sloping a little downward. An upward slope shows investors are moving into the stock at a slow drip. You’re banking on a big breakout coming soon.
To that end, a huge sell-off at a high trading volume should keep you away, as it indicates investors can’t get rid of it fast enough. Let them do the panicked investing, not you.
Pros and Cons of the Handle and Cup Pattern
The handle and cup pattern is a reliable marker of a promising, stable stock. However, like any other stock indicator, it must be wielded carefully to avoid potential drawbacks. Here are some advantages and possible setbacks of cup and handle pattern targets.
Advantages of the Handle and Cup Pattern
Some of the pros of the handle and cup pattern include the following.
Entry and Exit Points
The pattern gives solid indications of the best entry and exit points for a given stock.
Risk/Reward Ratio
Investors using the pattern can place stop-loss orders barely beneath the handle’s support level. This restricts potential losses but also sets a profit target for maximizing gains. Traders only get exposed to small risks for the opportunity to see big returns.
Strength Over the Long Term
The handle and cup pattern can be deployed in various investing timeframes. However, it’s most effective for traders eyeing long-term strategies as it can take several months or even years to play out.
Identification of Potential Breakouts
The cup and handle pattern gets more reliable as a signal when a breakout price is validated by higher-than-normal trading volume. This gives traders more confidence about their trade decisions since it implies that market interest in the stock is strong.
Potential Drawbacks of the Handle and Cup Pattern
Possible disadvantages of the pattern include the following.
Risky for Short-Term Investors
The handle and cup pattern takes a while to develop. The purpose of short-term investing is to generate quicker gains, so the pattern might not be compatible with these goals. The end goal of the cup and handle pattern is to eventually establish long-term stability, which can be good for value investors but not necessarily for more active traders.
Possible Misinterpretations
In any analysis, there’s always the risk of setting false signals. Investors need to validate the pattern rules to ensure that development truly supports the investment.
Subject to Market Volatility
Bear markets, or markets susceptible to unexpected news, may be too volatile to deploy the cup and handle pattern. It may give out false signals in those sectors and create the possibility for greater losses.
What Happens After Cup and Handle Patterns Emerge?
After a stock establishes a cup and handle pattern, what signals and strategies may emerge? Here’s a rundown of the possible outcomes and how they can be interpreted.
Verifying the Breakout
After the pattern is complete, the stock in question usually results in a breakout where the stock price moves above the resistance level. This generally leads to higher trading volume, which confirms the breakout status.
When that happens, investors who have been patiently waiting for this verification often take long-term positions as the stock continues to move upward.
Continuing Sustained Growth
The breakout can precede a continued uptrend as more investors trade for the stock. As long as the stock prices rise, more investors will be motivated to take positions. Some investors establish pattern targets based on the cup’s height, believing that the stock will surpass that breakout point. They may be able to sell their shares for significant profit.
Short-Term Pullbacks
The stock may experience occasional pullbacks, even if it successfully reaches the breakout point. These pullbacks are generally short-lived — they may be described more accurately as “corrections.” These could be opportunities for new investors to take positions in the stock with the expectation that it will reverse course and continue to grow.
Long-Term Strategies
The cup and handle pattern is always regarded as a positive sign for bullish market movement. However, even the most reliable stock market indicators are not ironclad guarantees of outcome. A failed breakout or price retraction may indicate that market sentiment is cooling on the stock. Make sure you manage expectations and keep objectively analyzing the stock’s progress to maximize your position.
The Handle and Cup Indicator in the Present-Day Stock Market
Looking at the present status of the stock market, how does the cup and handle pattern work in 2024 and beyond? Here are some of the stock market trends over the last year or so that could affect how the pattern may perform in the future.
Inflation
Extended inflation has been an issue for the last few years. Although the latest inflation rates are closer to average rates over the last century, there’s always a chance that they can rise and result in a volatile market. This runs the risk of more frequent and dramatic price swings, which could disrupt the cup and handle pattern, making it temporarily unpredictable.
Inflation also affects a company’s business fundamentals, resulting in profit squeezes and price hikes for raw materials. This too can result in the cup and handle pattern being disruptive.
Interest Rate Changes
Recent economic conditions suggest the Federal Reserve may consider lowering the going interest rates within a few months — though it’s never a certainty until it actually happens. When interest rates are cut, the market becomes more liquid since borrowing is less expensive. This improves investor’s sentiment and confidence in the stock, which could result in a breakout above the handle’s resistance point.
As a comparison, interest rate hikes reduce market liquidity. This drives investor uncertainty and restricted price movements, which may work against the cup and handle pattern. Rate hikes may make the breakout less impactful or lengthen the handle phase while confidence is low.
Potential Future Impact
Some future projections may have a considerable impact on the development of cup and handle patterns. One factor already playing a big part is the advance of artificial intelligence (AI). Stocks especially driven by AI may experience quicker price movements, which could make cup and handle patterns more active and constantly modified.
A few analysts expect small-cap stocks to flourish in the final months of 2024. This bodes well for some startups and could lead to rapidly developing cup and handle patterns in the short term.
If these companies maintain traction, the cup and handle could become more pronounced. However, the profusion of small market cap companies can result in market volatility, so the pattern should be carefully watched during those times.
Gorilla Trades: Setting a Pattern for Success
There are plenty of indicators to watch for in the stock market, and Gorilla Trades can help you learn how to use them all. Sign up for a free trial to find out more.
