The Cup and Handle is a popular technical trading setup that investors have used for several decades.
The chart pattern is simple; it consists of a large “U” shaped body and a small pullback to give a distinct look of a tea or coffee cup.
In this article, we’ll dive deeper into the Cup and Handle setup, looking at how to spot it, how to trade it, and what can be used to augment it for more profitable trading.
Contents
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- What Is A Cup And Handle
- Trading The Cup And Handle
- Additional Indicators
- Amp It Up With Options
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What Is A Cup And Handle
As briefly discussed above, the Cup and Handle is a technical chart pattern that is often used as a breakout signal to get long stock or options.
The Cup and Handle have a few distinct parts, and we will go through them below with letters matching their location on the chart.
A: The Decline often occurs from an upmove or some sideways consolidations. Price fades down and looks to form a bottom. This is the left wall of the cup.
B: The stock bottoms briefly and forms a rounded bottom. This is the base of the cup and will be important later for looking at potential profit points.
C: The 3rd phase is the rally off of the low. This forms the right wall of the cup and should be accompanied by an increase in buy volume.
D: The last phase is sideways consolidation. This forms the cup’s handle and is where a trade will be initiated. The handle could have a few forms, ranging from descending wedges or triangles to bull flags or pennants.
These chart patterns are fairly easy to see based on their distinct shape and structure.
Once the “U” shaped cup has formed, a ticker could be added to a watch list to keep an eye on over the next few sessions to see if that distinctive handle is formed.
Trading The Cup And Handle
The cup and handle is strictly a bullish breakout pattern, and trading it is pretty simple from a management perspective, but there are a few different ways to enter based on the setups.
The first way is to draw a trendline across the tops of the candles that form the handle.
When a candle closes above this trendline, the trade is initiated.
This buy location will give you the best risk and reward but also could have you early in the trade.
The second way to enter the trade is when the price closes above the top price of the cup formation.
This location offers a slightly worse risk-to-reward ratio but often has a higher success rate since the buying has already resumed.
Both can be seen in the example of Apple Below.
The first entry style would be the red arrow, and the second would be the green.
So now that we have the two entry locations set, what about profit targets?
The profit target on a cup and handle is usually the distance from the bottom of the cup to the “rim,” designated here by the red horizontal line.
In the case of Apple’s example above, it would be roughly 30 points from the red entry.
Finally, there is the stop loss.
For the cup and handle trade, the most common location for a stop loss is below the lowest point on the handle.
For the example above, it would be around the $143 level.
Additional Indicators
Although this pattern is pretty simple to see and trade, confirmation of additional indicators can be a great way to gain some additional confidence in the trade.
The Moving Average Convergence Divergence (MACD) and the Momentum indicator are two commonly used indicators.
Both indicators are on the example chart below but can be used individually or in unison.
First, let’s look at the MACD. To use the MACD as a confirmation indicator, there are two places to watch.
First, look for the histogram to be either green or moving from red to green.
The second is the signal line and moving average.
These should be over the 0 level; ideally, the signal line should be above the average.
These conditions do not need to be true, but the more they are, the better the potential signal will be.
In the example above, the green arrow is where all the conditions are met.
Second, we will look at the momentum indicator.
This is a lot less complicated as it is only one line.
Using the momentum indicator as a confirmation signal only requires the signal line above 0.
A bonus is if momentum is increasing, but it is considered valid as long as it’s above the 0 line.
Other indicators like the RSI, ADX, and even moving averages can also be used effectively, but it all comes down to what you are comfortable looking at.
Many traders opt for nothing and only rely on the chart pattern for an entry and exit point.
Amp It Up With Options
Options are a fantastic way to supercharge the cup and handle the pattern.
Longing a call option would be the most basic way to increase the potential return of the cup and handle.
This strategy has a few potential drawbacks, though, first is the timing component.
Buying a few weeks to a few months will help keep the option from expiring before the move occurs, but it’s still possible.
You will also have IV and theta decay working against you, so if the move is a slow grind higher, it’s possible to lose money on a long call.
Verticals are another strategy that can be employed here, and both the credit and debit spreads have a benefit over a straight, long call.
The credit spread will put theta decay on your side and make how long the move takes irrelevant.
You will be profitable if the price is above the sold strike at expiration.
A debit spread also offers an advantage; you can control the in-the-money calls for less capital expense thanks to the offsetting cost of the sold call.
To learn more about debit spreads, check out this article.
Lastly, in-the-money LEAPS could be used to control the stock using the leverage of a call without as much of a time component.
While this is similar to the long calls above, the additional time and in-the-money strike help remove some of the theta decay and expiration risks from the trade.
Additionally, you would have a set exit based on the underlying price.
LEAPs can be a great way to increase leverage and potential profit on the cup and handle
The cup and handle is a favorite chart pattern of technical breakout traders.
It’s easy to spot, has defined entry and exit criteria, and can be used on almost any instrument.
Options add another layer of profitability to the cup and handle by allowing you, as a trader, to use leverage to increase the profitability of the trade or spreads to benefit from the directional moves.
Finally, utilizing additional indicators as confirmation signals can help you enter optimal locations to maximize profit.
Whether you are new to trading or an options pro, the cup and handle should be in your arsenal.
We hope you enjoyed this article on the cup and handle pattern.
If you have any questions, please send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
Original source: https://optionstradingiq.com/cup-and-handle/