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Username Post: What is the Cup and Handle Pattern?
Posts 249
04-27-09 10:48 AM - Post#2861    

The Cup-with-Handle is a pattern on bar charts resembling a cup with a handle. The cup is in the shape of a "U" and the handle has a slight downward drift. The right-hand side of the pattern has low trading volume. It can be as short as seven weeks and as long as 65 weeks. As the stock comes up to test the old highs, the stock will incur selling pressure by the people who bought at or near the old high. This selling pressure will make the stock price trade sideways with a tendency towards a downtrend for four days to four weeks, before it takes off. The Cup with Handle is a bullish continuation pattern that marks a consolidation period followed by a breakout. As its name implies, there are two parts to the pattern: the cup and the handle.

The cup-and-handle pattern is preceded by an upward move, which stalls and sells off. The sell-off is what forms the initial part of this pattern. After the sell-off, the security will basically trade flat for an extended period of time, with no clear trend. The next part of the pattern is the upward move back towards the peak of the preceding upward move. The last part of the pattern, known as the handle, is a relatively smaller downward move before the security moves higher and continues the previous trend. The cup forms after an advance and looks like a bowl or rounding bottom. As the cup is completed, a trading range develops on the right hand side and the handle is formed. A subsequent breakout from the handle's trading range signals a continuation of the prior advance.

The theory of cup with handle was developed by William O’Neil and introduced in his book “How to make money in stocks” in 1988. In the early 1960's, William O'Neil & Co. created the first daily computer database on the stockmarket in the United States. In 1970, the company created Datagraphs, institutional investors' service. Today, more than 600 top institutional investors take a wide variety of such research services. William O’Neil is an American entrepreneur, stockbroker and author, who also holds the distinction of starting his career in stock market at an early age of 25 years and bought a NYSE ticket at an age of 30 years. He also developed the ‘CANSLIM’ theory, apart from the ‘Cup with Handle’ theory.

It has been said that William O'neill averaged 40+ percent annual returns (see Market Wizards book) but there are no audited results that have been shown. However, O'neill's followers David Ryan, Lee Freeston, Cedd Moses, Gil Morales all proceeded to win U.S. Investing Championships and U.S. Trading Championships. There is some merit to his system.

The main advantage of using the cup and handle theory in financial markets is that the pattern signals the reversal of trend at an early stage. It could be either be the case when a series of rising peaks is followed by a reversal in trend. It also gives an early indication when a series of lower bottoms is followed by a bullish pattern. A rather accurate estimation of the expected price rise is found by measuring the price rise from the bottom of the cup to the right side. The reason for a price rise following a cup and handle formation is largely unknown, though some have theorized that it may be partially due to the fact that analysts who know the formation well will buy shares of the stock, causing the price to rise.

Critics argue that the Cup-and-Handle patterns lead to a lot of whipsawing losses during bearish markets or markets locked in trading ranges.

There are several nuances with the Cup-and-Handle pattern. O'neill does not like wild and loose bases because they are not sound bases to break out from. He also guards against wedging action, where the price lows slowly creep up within the handle. Wedging action fools the untrained observer into thinking that a shakeout took place. But because of the lows "wedging higher", the reality is the shakeout never took place, leading to more prone failures when the stock breaks out of the handle pattern.

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