What is a cup and handle pattern in trading?

What is a ‘cup and handle’ pattern?

A cup and handle pattern is a classic technical formation that many traders closely monitor for potential trading opportunities. This bullish continuation pattern emerges after an asset experiences a brief pullback following a sustained uptrend.

Identifying the cup and handle pattern requires a keen eye for market structure and a solid understanding of price action dynamics.

As one of the more recognisable technical formations, the cup and handle offers traders valuable clues about the underlying momentum and potential future direction of an asset.

The pattern is characterised by two distinct phases – the ‘cup’ and the ‘handle’. The cup resembles a U-shape, representing a brief retracement in price following a bullish period. This retracement is typically more rounded in nature, rather than a sharp V-shape, signalling an orderly pullback rather than a breakdown.

The handle phase that follows is a smaller consolidation range, often forming a downward-sloping channel. For it to qualify as a handle, the price decline can’t be more than half of the cup. Ideally, the handle shouldn’t extend beyond more than one-third of the cup.

This handle represents a final period of selling pressure or indecision in the market, before bullishness returns. Once the asset breaks out above the handle's resistance level, it often signals the resumption of the underlying bullish momentum.

Experienced traders monitor cup handle patterns closely, as their appearance can provide well-defined entry points in time for the next bull phase. By identifying this pattern and confirming it with other technical indicators, traders can time their long positions with greater precision and confidence.

The cup and handle's distinctive pattern makes it a valuable addition to any trader's technical analysis toolkit. Nevertheless, there are limitations to the pattern that we will go through in greater detail below.

What is an ‘inverted cup and handle’?

The inverted cup and handle pattern is the mirror image of the regular cup and handle formation. It signals a potential bearish continuation in the underlying asset. This pattern emerges after a prolonged downtrend, where the market experiences a brief respite before resuming its downward trajectory.

The inverted cup and handle starts with a n-shaped dome, representing a brief and ‘round’ rebound in price as the bearish momentum takes a back seat. This is followed by a smaller handle formation, which takes the shape of an upward-sloping consolidation range.

Here, traders watch closely for a break below the handle's support level, as this can indicate the resumption of the broader bearish trend. Once the asset decisively breaches this support, it often triggers a fresh wave of selling pressure, potentially leading to further price drops.

As with the bullish cup and handle pattern, the inverted cup handle pattern (when cross-checked with other technical indicators) could be a valuable tool for trades looking to get exposure to bearish trends and enter a well-defined short position.

How to identify the cup and handle pattern

The first step in identifying a cup and handle is to look for a clear price uptrend of an asset. This establishes the necessary bullish backdrop for the pattern to develop.

The cup portion of the formation should then take shape, featuring a smooth, rounded decline that retraces a portion of the prior uptrend, typically between 30% to 50% of the move. The key is for this retracement to occur in an orderly, controlled manner, without any sharp, vertical drops that would invalidate the pattern.

Once the cup is formed, traders would monitor the development of the handle phase. This is characterised by a smaller, sideways consolidation range, often with a slight downward bias. The duration of the handle is usually shorter than the cup, taking between one week and four weeks to play out (versus an estimated five months for the cup).

The main thing to observe in the handle is that it holds at least 50% above the lowest point of the cup. This would signal that the underlying buying pressure is still intact. A decisive breakout above the handle's resistance effectively completes the cup and handle pattern, potentially triggering the next uptrend.

By identifying these distinct visual cues and confirming the pattern with supporting technical indicators, traders can increase their chances of capitalising on the potential bullish signals that the cup and handle presents. As with any trading strategy, prudent risk management remains paramount to maximise your chances of success.

Advantages and disadvantages of the cup and handle pattern

Advantages of the cup and handle pattern:

• Recognisable pattern formation: the classic U-shape of the cup and the subsequent handle consolidation phase create a distinct chart pattern that’s easy to spot
• Bullish continuation signal: the cup and handle is a continuation pattern, signalling the potential resumption of the underlying uptrend after a brief pullback. This gives traders looking to enter long positions greater assurance and clarity
• Provides clear entry and exit points: the breakout above the handle's resistance level offers a well-defined entry point, while the pattern's structure helps traders establish logical stop-loss and profit-taking levels

Disadvantages of the cup and handle pattern:

• Potential for false breakouts: the cup and handle pattern can sometimes lead to false breakouts (or fakeouts), where the price fails to follow through after the handle's resistance is breached, leading to sudden reversals
• Subjective pattern identification: determining the precise boundaries of the cup and handle can be somewhat subjective, as the pattern's visual characteristics and reliability can vary across different market conditions and asset classes
• Susceptibility to market noise: the cup and handle pattern can be distorted or obscured by erratic price action and market volatility, making it challenging to identify and trade the pattern with confidence in certain environments

How to use the cup and handle pattern when trading

You can trade using the cup and handle pattern via a CFD account. CFDs enable traders to participate in the price movements of an underlying asset without actually taking direct ownership of the asset itself.

The first step in trading cup and handle patterns with a CFD trading account is to identify the formation on the asset's price chart. Look for the characteristic U-shaped cup, followed by a smaller consolidation range forming the handle.

Next, confirm that the cup retracement is within the typical 30% to 50% range of the prior uptrend, and that the handle's length is shorter (usually lasting between one week and four weeks) than the cup's duration (usually lasting a few months).

Once the cup and handle pattern is established, the next step is to monitor the price action closely as it approaches the top of the handle. This is a critical juncture, as a breakout above the handle's resistance level could signal the potential resumption of the bullish trend.

When this pattern forms, some traders may observe the breakout as a potential signal. Traders who choose this approach typically monitor the low point of the handle as a reference level, and may use the cup's height as one method for calculating potential price projections. As with any pattern, false signals can occur, which is why risk management strategies like stop-losses are important to consider.

Finally, as the trade progresses, closely watch for any signs of momentum shifting in your favour. You can utilise trailing stop-loss orders to lock in possible gains and protect your position as the asset moves in the anticipated direction.

Increased trading volume during a breakout may be viewed as a potential confirmation signal. Traders who follow volume analysis sometimes incorporate this indicator into their decision-making process when evaluating pattern strength. As with all technical signals, this is just one of many factors that market participants might consider within their overall analysis framework.

Below is a step-by-side guideline on how to trade the cup and handle pattern:

1. Open a CFD trading account or log in
2. Select the market you want to trade on
3. Identify the cup and handle pattern
4. Select your position size and manage your risk
5. Open and monitor your position

Cup and handle pattern in trading summed up

• The cup and handle pattern is a price formation studied in technical analysis that some traders interpret as a potential continuation signal
• The pattern features a U-shape and a subsequent downward-trending handle formation
• The first step in identifying cup handle patterns is to look out for clear and defined uptrends
• Advantages include an easily recognisable pattern and the assurance it can provide traders looking to open long positions
• Disadvantages include potential false breakouts (or fakeouts), as well as susceptibility to price volatility
• The inverted cup and handle is a bearish continuation pattern, signalling selling opportunities with an n-shaped dome and an upward-trending handle
• Traders can use leveraged derivatives like CFDs to get exposure to both bullish and bearish cup and handle formations, without directly owning the underlying asset