Tips on Technicals - Cup with Handle
Often, a single technical formation incorporates the rules of other patterns. This illustrates the concept that no one technical signal is good enough to stand by itself. Rather, when several indicators signal concurrently, each is reinforced and the likelihood of a correct trading decision is increased geometrically. One such pattern is called the "cup with handle."
Basing Pattern
The cup with handle pattern is commonly applied to the stock market although any market with daily volume data should theoretically work the same. The pattern gets its name from its appearance of a coffee cup with a handle on the right.
After a rally, the stock settles into a downward correction pattern that usually lasts three to six months. This forms the left side and bottom of the cup. When prices start to rise again, volume increases until the old high is reached. This forms the right side of the cup.
What has happened so far is that the market rallied and then corrected on lower volume. Figure 1 shows a clear pattern in FSI International. The bottom of the cup shows unusually low volume which refutes the notion that the trend had reversed lower. In this case, the right side of the cup starts when prices break out of the trading range at the cup's bottom. Volume spikes up which is exactly the confirmation needed for any trend line break.
At the old highs, selling pressure increases from both those who failed to sell earlier at that level (second chance to sell) and those who bought at the cup bottom (profit takers). Now the market drifts lower in a smaller correction called the handle. Volume eases as prices drop indicating a lack of sellers. When the handle pattern is broken, volume spikes again and the stock is off and running.
Handles should never dip too far into the cup and usually last a few short weeks. Deep handles indicate a larger trading range rather than a small correction in a rising market.
As in most real world situations, the cup with handle is not always a text book case. Household International (figure 2) had two deviations from the ideal. First, the right side of the cup did not quite reach old high. Second, the handle was shaped like a triangle rather than a flag. As a metaphor, the latter would be easier to hold but both show downward movement of prices on lower volumes. As long as the other criteria are met, these imperfections can be tolerated.
The buy signal in figure 1 was given when the stock made a new high after the handle breakout. In figure 2, the signal is given when prices break the downtrend line formed by the cup's two peaks.
Rules of the Game
Besides those mentioned above, there are several other rules to apply to the pattern. First, the shape and depth of the cup are important. The depth of the cup should be in proportion to the width. There are specific levels that many market experts use but we can generalize here. The depth of the cup should be 20-30% of the peak price. Shallower cups do not give the weak bulls enough incentive to get out. Deeper cups can require the stock to double in price before the buy signal is even completed.
Cups should not be too sharp either. The "v-shaped" bottom does not give the stock sufficient time to form a solid base. The bottom line is that the cup should look like a cup, not a dish and not a champagne glass.
The final indicator to watch is the 200-day moving average. As in other analyses, when a stock gets too far above the average a correction usually follows. A valid handle breakout occurs at prices less than 65% above the average. Momentum indicators such as rate of change and relative strength index are likely to show overbought conditions at higher percentages.
Figure 3 shows Genesco Inc. The cup's bottom found support on the 200-day average (except for the early November selling climax). Even though the right side overshot the left, volume spiked during both the rise and at the handle breakout.
The cup with handle pattern is a clear continuation pattern. Should the handle dip below the 200-day average, chances are that the average is flat and the market is not in a true intermediate-term rally. In that case, any continuation pattern breakout would be suspect.
As a basing pattern, the cup with handle is well defined by the multiple technical indicators that comprise it. This allows its signals to be quite clear.
