Introduction
You have been trading for a while now, and you are always on the lookout for patterns that can offer you an edge in the market. You have heard of the Cup and Handle pattern, but what exactly is it? Let's find out.
How to identify a Cup and Handle pattern?
A cup and handle pattern has two parts: the cup and the handle. The cup is a rounded bottom that forms after a strong uptrend. It may be deep or shallow, based on the depth of the correction. The cup should be smooth and symmetrical, without sharp edges or spikes. The cup must have a similar volume on both sides, showing a balance between buyers and sellers.
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The handle is a downward-sloping consolidation on the cup's right side. It must be smaller than the cup in terms of length and depth. The handle must also have a declining volume, suggesting decreased selling pressure. The handle should not drop below the midpoint of the cup; otherwise, the pattern becomes invalid.
The cup and handle pattern is confirmed when the price breaks above the resistance level of the handle, which is also the cup's rim. It should be accompanied by a surge in volume, implying an increase in buying pressure. The breakout signals the continuation of the original uptrend and the start of a new bullish phase.
Calculating Cup and Handle pattern
To measure the potential target for the cup and handle pattern, you can use the following formula:
Target = Breakout + (High - Low)
This formula gives you the minimum expected price movement after the breakout.
To measure the stop loss level for the cup and handle pattern, you can use the following formula:
Stop Loss = Breakout - (High - Low) x ATR
This formula helps you figure out when it is a good time to leave the trade if the price goes in the opposite trend.
How to trade a Cup and Handle pattern?
Different strategies for trading a cup and handle pattern exist, depending on your risk appetite, trading style, and market conditions. Here are some of the most common ones:
- Breakout Entry: You enter the trade when the price breaks above the resistance level of the handle, with a surge in volume. Depending on your risk tolerance, you place your stop loss below the low of the handle or below the midpoint of the cup. You redeem from your position when the price reaches the target or shows signs of reversal, such as a break below a support level or a moving average.
- Pullback Entry: This is a more conservative strategy. You wait for the price to break above the resistance level of the handle, with a surge in volume, and then pull back to retest the breakout level. Entry in the trade is best when the price bounces off the breakout level, confirming the validity of the pattern. Depending on your risk tolerance, you place your stop loss below the low of the pullback or below the low of the handle. You leave the trade either when the price hits the target or when there are indications of a turnaround, like breaking below a support level or a moving average.
- Confirmation Entry: This is a more aggressive and risky strategy. Before the price breaks above the handle's resistance level, you enter the trade expecting a breakout. Put your stop loss below the handle's low or the cup's low, depending on how much risk you are comfortable with. Leave the trade when the price hits the target or if there are turnaround signals, like breaking below a support level or a moving average.
Advantages and drawbacks of different strategies
- The advantage of the breakout entry strategy is its high probability of success. It also has a clear entry and exit point, which makes it easy to execute. The disadvantage is it may miss some of the initial price movement.
- The pullback entry strategy offers a better risk-reward ratio. It also has a higher chance of catching a valid breakout. The downside of this strategy is that it may miss some of the trades.
- The confirmation entry strategy has a higher potential profit. It also has a lower chance of missing a trade. The disadvantage is it has a lower probability of success.
Conclusion
This chart pattern indicates an uptrend continuation after a consolidation phase. Its confirmation occurs when the price breaks above the handle's resistance level, accompanied by increased volume. Add the cup's height to the breakout level to set a target. Determine the stop loss by subtracting a portion of the cup's height from the breakout level.
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