The Cup with Handle

When we look at technical formations, we typically find they fall into one of two categories; continuation formations and reversal formations. One of our favorite continuation formations is called the “Cup-with-handle” formation or the “Cup-and-saucer” formation. It’s a continuation pattern that has very specific characteristics and, maybe more importantly for disciplined investors, it gives measuring implications to the upside when you’ve identified it. It’s a somewhat uncommon formation and forms over various time spans (i.e. daily charts, weekly charts).

As the name logically implies, there are two distinct sections of this particular pattern: 1. The cup and 2. the handle. The cup forms after a normal advance and has the same look as a typical rounding bottom formation. In reality, the cup looks like an ordinary bowl you’d find in your kitchen. As the cup comes to completion, a short-term trading range develops on the right hand side and this range comprises the handle. A subsequent breakout from the handle’s range signals a continuation of the prior advance and thus completes the formation.

As with most technical formations, it’s not simply a visual pattern we’re looking for. There are several qualifiers that go along with the cup-with-handle pattern and traders should be sure that each of the qualifiers has been met before “throwing their hat in the ring” and trading on the signals. There’s an old German proverb that says “Ordung ist das halbe Leben” or “Order is half to life” and you can certainly relate this to trading. Order and discipline are the absolutes for successful traders so be sure to confirm all the signals line up for this pattern. Here are the confirmatory signals for the pattern.

I. Trend - To qualify as a continuation pattern, a prior up trend must exist. If you’re looking at a daily chart, ideally, the trend should be a few months old and not too mature. On a weekly chart, you simply multiply this time frame out. The more mature the trend, the less likely it is that you’ll get a solid pattern to work with.

II. Cup - The cup should be "U" shaped and resemble a mixing bowl or rounding bottom formation. Often times, you’ll see "V" shaped bottoms in the market but these are considered too sharp of a reversal to qualify. The softer "U" shape confirms that the cup is a consolidation pattern with a strong line of support at the bottom of the cup. The ideal pattern will give equal highs on both sides of the cup, but this is more of a “ideal” situation than it is a set in stone portion to the rule.

III. Cup Depth - Ideally, the depth of the cup should retrace a third or less of the most recent advance. However, the retracement could range from 1/3 to 1/2.

IV. Handle - Typically, the high on the right side of the cup will match the high level set on the left side. After the high forms on the right side of the cup, there is a pullback that defines the handle. Often times, this handle will come in the form of another technical pattern. In fact, I would even go so far as to say that most formations will have a handle that is defined, in a smaller time frame, by a technical pattern. In the past, I’ve seen handles that took the shape of a flag, pennant, or short double-bottom. In essence, the handle represents the final consolidation before the big breakout and can retrace up to 1/3 of the cup's advance during it’s pulldown. The smaller the retracement is, the more bullish the formation and significant the breakout.

V. Duration - The cup can extend from 1 to 6 months and often times longer on weekly charts. The handle can be from 1 week to many weeks but ideally completes within 1-4 weeks. Keep in mind, the handle is a very short-term phenomenon. It’s basically formed because the stock has come up to resistance at the top of the cup and, as we often see when stocks approach resistance, weak handed investors that bought near those old highs are clearing out their positions simply thankful that they were able to get their money back.

VI. Volume – In an ideal volume, both ends of the cup should show heavy volume and the action that forms the cup in the middle section should see thin volume. The heavy volume on the right side will be the volume that breaks the stock out of the handle. Furhter, volume should be decreasing as the handle’s being formed. The last thing you want to see is a stock hitting resistance and then pulling back on heavy volume. This type of action would invalidate the pattern.

VII. Target – As I mentioned earlier, one of the best parts about the formations is that it gives a trader a defined upside projection. The projected advance after breakout can be estimated by measuring the distance from the right peak to the bottom of the cup. You simply add the difference of these two numbers to the top of the cup and this tells you how far the issue should travel after the break.

Now, let’s take a look at a real life example. The chart below is a look at a cup-with-handle break for Rediff.com India Ltd (Symbol: REDF). What you’ll notice right off the bat is the cup or bowl type rounding in the formation and the extreme move that the issue made after the break was confirmed. Let’s dissect the breakout step by step.

I. Trend – REDF was most certainly in an up trend prior to the cup forming (ascending arrow). Most likely, the issue simply got ahead of itself and that’s the reason the cup formed.

II. Cup – The cup for this particular formation was very much “U” shaped and gave highs on the right and left side that were almost set at the exact same price.

III. Cup Depth – In this particular circumstance, REDF was on a BIG move after being basically dormant for quite some time. Thus, the fact that the stock retraced about half of the previous move does nothing to diminish the pattern. It retraced a bit more than you’ll normally see. However, with of the more thinly traded issues, you can expect a bit more retracement.

IV. Handle – REDF gave us an absolute textbook handle. The stock consolidated nicely on increasingly thinning volume right up until the point where it broke. Notice the exponential increase in volume when this one broke. As well, notice that the handle came in the form of a pennant consolidation, a short-term consolidation pattern.

V. Duration – The formation lasted roughly 3 _ months, which lies in our ideal time frame. Keep in mind the duration numbers are simply a guideline. We’ve seen formations on a weekly chart that have taken several quite some time to form.

VI. Volume – The volume on REDF came in perfectly. We saw tremendous volume on the first move that defines the left side of the cup. As well, volume increased dramatically as the stock broke from the cup. I’ve circled the volume at both ends. You can really see how dramatic the action was at the ends of the cup and how thin it was in the body. Finally, we saw the volume thinning out considerably in the handle, which is the quiet before the storm.

VII. Target – As you can see from the chart, the stock measured our perfectly. The bottom of the cup to the top spanned roughly $3. Thus, we’d expect REDF to run $3 after it broke out and that’s exactly what it did. The break came around $4.50 and the stock peeked around $7.50. Notice that the day REDF hit it’s measuring implication, it also formed a one-day reversal. Stocks will often times reverse around their measuring implication as this is the area astute traders know to target.