How To Trade The Inverse Cup And Handle

The Inverse Cup and Handle is the bearish counterpart to the popular Cup and Handle setup.

The chart pattern is just as simple; it consists of a large inverted “U” shaped body and a small upward consolidation to give a distinct look of an upside-down tea or coffee cup.

In this article, we’ll dive deeper into the Inverse 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

            • What Is An Inverse Cup And Handle
            • Trading The Inverse Cup And Handle
            • Additional Indicators
            • Options

What Is An Inverse Cup And Handle

The Inverse Cup and Handle is a technical chart pattern often used as a breakdown signal to get short an instrument or, at the very least,  to exit a long position.

The Inverse Cup and Handle has a few distinct parts, and we will go through them below with letters matching their location on the chart.

inverse cup and handle

A: The first step is the incline, often after a down move or some sideways consolidations.

The price rises and looks to form a top, which is the left wall of the inverted cup.

B: The second step is a rounded top. Price chops around, and there is no consistent movement in either direction; this is the top of the inverted cup and will be important for looking at potential profit points later.

C: The 3rd phase is the decline/sell-off from the high; this forms the right wall of the inverted cup and should be accompanied by a volume increase.

D: The last phase is sideways consolidation with a slight upward bias. This forms the teacup’s handle and is where a trade can be initiated. The handle could have a few forms, ranging from ascending wedges or triangles to bear flags or pennants.

These chart patterns are fairly easy to see based on their distinct shape and structure; however, the inverted cup and handle can be a lot messier in structure than the regular cup and handle.

The main thing to look for is the completed inverted “U” to let you know to start looking for a handle to form.

Trading The Inverse Cup And Handle

Since this pattern is strictly a breakdown pattern, trading it is pretty straightforward from a management perspective.

However, there are a few different ways to enter based on the setups.

The first way is to draw a line across the bottoms of the candles that form the handle.

When a candle closes below this trendline, the trade is initiated.

This short entry 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 below the bottom price of the inverted cup formation.

This location offers a slightly worse risk-to-reward ratio but can get you in a trade earlier if the handle formation never shows up.

Below is an example of two entry locations on the QQQ chart.

The first arrow is the worst entry, and the second arrow would be the “correct” location for the trade.

inverse cup and handle

Now that we have set up the two entry locations, let’s look at profit targets.

The profit target on an inverse cup and handle is the same as the regular cup and handle, the distance between the neckline and the top of the rounded top.

In the case of the example of QQQ below, it would be roughly 50 points from the bottom of the cup entry.

inverse cup and handle

Finally, there is the stop loss.

For the inverse cup and handle trade, the most common location for a stop loss is above the highest point on the handle, but on the example above, it would have stiped you out in mid-April, but you could have taken the trade again when it broke back through the neckline.

Additional Indicators

Although this pattern is simple to trade, confirmation of additional indicators can be a great way to gain additional confidence in the trade.

Similar to the regular cup and handle, two commonly used indicators are the Moving Average Convergence Divergence (MACD) and the Relative Strength Index.

Both indicators are on the example chart below but can be used individually or in unison.

inverse cup and handle

First, let’s look at the MACD.

There are two places to watch if you want to use the MACD as confirmation.

First, look for the histogram to be either red or moving from green to red.

The second is the signal line and moving average.

These should both be below the 0 level; ideally, the signal line should be below the average.

All of these conditions do not need to be met, but the more they are, the better the potential signal will be.

Second, we will look at the RSI.

This is a lot less complicated as it is only one line.

Using the RSI as a confirmation signal, we are looking for the line to be under the moving average, and both are trending down.

Ideally, they will both also be below 50.

One can use other indicators like momentum, ADX, and even moving averages to confirm an entry signal; it just comes down to what you are comfortable looking at.

Many traders opt for nothing at all and only rely on the chart pattern for entry and exit points.

Options

Similar to the cup and handle, options are a fantastic way to leverage up the inverse cup and handle pattern.

This is a better way to trade it in some cases, given that shorting stock can be dangerous for your account.

Longing a put option would be the most basic way to trade the pattern.

This strategy has a few potential drawbacks, though, first is the timing component.

Buying some time will help keep the option from expiring before more occurs, but in the case of the QQQ trade above, it still took several months to work out.

You will also have IV and theta decay working against you, so if the move is a slow grind lower, it’s still possible to lose money on a long put.

Verticals are another strategy that can be employed here, and both the credit and debit spreads have a benefit over a straight long put.

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 below the sold strike at expiration.

A debit spread also offers an advantage; you can build the spread to help offset the cost of the long put by selling a put short.

Lastly, at-the-money LEAPS could be used.

This helps to remove the time component but still gives the fixed-risk nature of an option.

While this is similar to the long puts above, the additional time and at-the-money strike help remove some of the theta decay and expiration risks from the trade.

You could also trade these like the actual stock and have a set stop loss based on the underlying stock.

This can help avoid one of these trades being a total loss on the option.

The inverse cup and handle can be a great technical setup for breakdown.

It’s fairly easy to spot, has a defined set of entry and exit criteria, and can be used on almost any instrument.

Options add another layer of profitability and protection to the inverse 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 without worrying about decay.

Finally, utilizing additional indicators as confirmation signals can help keep you from entering suboptimal locations.

Whatever your trading style and timeframe, the inverse cup and handle should be in your trader’s toolbox.

We hope you enjoyed this article on inverse cups and handles.

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.

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Original source: https://optionstradingiq.com/inverse-cup-and-handle/

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