Cup and Handle Pattern in Technical Analysis: Formation and Trading

Chart patterns that signal price changes play an important role in a trader’s work. One of them is the “cup and handle” formation.

What the pattern looks like

The name “cup and handle” was chosen because of the obvious resemblance between this piece of tableware and what a trader sees on the chart. It is hard to say how popular this pattern is among market participants, since there are other formations of greater practical interest.

The cup: formation conditions

The key precondition for this pattern is a bullish trend, even though analysts classify it as a reversal pattern. The cup and handle forms when the previous upward move is being corrected. The trader must pay close attention to how deep the pullback is.

The pattern is worth trading if the pullback does not exceed 80% of the trend that preceded this formation. The bottom of the cup corresponds to a period of price consolidation, after which the price starts to climb.

The handle: formation conditions

On the chart, the handle is nothing more than a price correction relative to the levels reached while the right side of the cup was forming. Analysts compare this section not so much to a handle as to a flag. The most interesting case is when the flag starts forming right after the right side of the cup is complete. The length of the handle should not exceed 50% of the right side of the cup.

This part of the chart takes quite a long time to form. A long time span points to a trend that follows. The section is only complete once the resistance level is broken.

In practical terms, this is what we see on the chart: as the left side of the cup is drawn, prices gradually decline; while the bottom forms, they stay steadily low; and while the right side forms, they gradually rise. At the moment of the breakout, the number of trades rises sharply.

How to trade the pattern on Forex

You can trade the cup and handle using one of the following approaches:

• aggressive;
• conservative;
• standard.

Each of them has its pros and cons. The pattern is rarely used among Forex methods because it requires taking many factors into account at once; otherwise the risk of a mistake is very high. Particular difficulties can arise when analysing the depth and width of the shape drawn by the chart. The chance of missing a profitable move with this pattern is quite high.

Aggressive entry

This is considered the riskiest approach. It is based on the behaviour of the handle. Orders should be placed after the handle is broken — in other words, after the breakout of the flag. The stop is set below the level of the breakout candle.

Standard entry

With the standard approach, positions are opened right after the breakout of the pattern line. The stop loss should be below the handle, i.e. below the line that forms resistance.

Conservative entry

This is the most commonly used approach. It follows classic trading tradition and focuses on the breakout of the technical line. The ideal option is to enter after a retest of the breakout line. The stop loss should be below the handle or below the candle that bounced off the breakout line (at least if that candle is large enough).

False pattern

Not every pattern that forms is genuine. A trader must know the signs of a false cup well. There are several of them:

1. A genuine cup and handle must always be preceded by an uptrend.
2. The reliability of the pattern is checked against the timeframe. The higher it is (H4, D1, W1), the more likely the cup is genuine.
3. The next criterion is the breakout. Very often it turns out to be a false breakout, which means prices are heading back. This part of the chart should sit slightly below the high that marks the end of the right side of the cup — roughly 5–15% lower.
4. It also matters how
   correctly the outline of the cup was formed
   . Experts believe that for a “correct” shape you can calculate the arithmetic mean between the high of the left side and the low of the bottom. The arithmetic mean between the low and the high of the handle is calculated the same way. When you compare the two, the value for the handle will be greater than the value for the cup.
5. To confirm the pattern, traders use a moving average with a period of 200. It must always stay below the handle.

Inverted pattern

Logically, if the cup and handle exists, the chart can also form an inverted version of it. In this case it would be a “bearish pattern”. However, William O’Neil, who created the method, never mentions such a setup. So the theory has not been confirmed in practice: there are no accounts of how the inverted cup and handle has been used.

Debates about whether to use this pattern started fairly recently, although the possibility itself was noticed and worked out several years ago. Since the setup is extremely rare, not everyone gets the chance to try it and test how effective this trading method is.