Reading stock charts is a great skill for a novice investor to develop. It can help you decide when to buy into positions that will yield the most profit. But 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.
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 tea cup 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 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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.