What is a cup with handle pattern?
The cup with handle pattern or base is a very strong base a stock can form. After a strong run, a stock will often correct and consolidate before it can move up again. Stocks form various patterns when they do this, some patterns being stronger indications of a potential strong move to come. The cup with handle is one of these patterns.
The pattern looks just like a cup, while the handle is more of a downward slanting line and not really the type of handle we are used to seeing on a teacup. I have attached the chart of one of our current plays that we picked up as it broke out of its cup with handle pattern. (Click to view chart)
The left side of the cup starts with the highs in late August and early September of 1999. The stock then sells down to the bottom of the cup in November. In December it starts to build the right side, and in late December through early January it starts to form the handle as it begins a sideways to slightly down move on very low volume. It then races up out of that handle, breaking out when it surpasses the intraday high of the handle.
When looking at cup with handle patterns, it is not enough to look just at the price. Volume action in relation to the price is very critical. We want to see volume rising on those days the stock moves up, and falling on those days it moves down. This won't happen on every day of the base, but we want it to happen more than 50% of the time. As the stock moves through its handle, we want to see volume really contract. This is when the last sellers are shaken out as the stock drifts slightly lower. The low volume tells us that there are not many sellers.
Once the last sellers are gone, then it is a question of supply and demand. The strong holders are left after the handle shakeout, and they won't sell until the price is bid up to a level they want. The breakout occurs when the stock moves past the intraday high in the handle. Volume must also 'breakout' as well, hitting at least one and one-half times the 50 day average volume on the move.
It may seem ridiculous, but when a stock traces out this pattern, it can be on its way to huge gains. CSCO did it before it started its incredible run; DELL did it as well. The chart traces out investor psychology as a stock corrects. The late comers buy at the top. Some sell as it starts to fall, others hang on until hoping for better days. After it trades sideways long enough, something triggers accumulation, and the stock starts to build the right half of the cup. As it approaches the point where it started to correct, those latecomers that stayed with the stock all this time begin to sell-they are finally getting their money back. That is why the stock drifts sideways and slightly down in the handle; those who were hanging on to get their money back are getting out. If only they knew what was transpiring. Once these last sellers are gone, the stock has hit bottom and is ready to move up.
These bases can last many months or a matter of weeks. Theory has it, however, that it should not be shorter than seven weeks as that is the minimum amount of time needed to get all of the sellers or weak holders weeded out of the stock so it can sustain a strong move up.
These bases can still fail even if it follows the 'rules' to the letter. As with all things relating to the stock market, it is investor sentiment that ultimately rules, and if something upsets the apple cart, not even a strong base can overcome selling sentiment. That is why we always need to keep a strict set of stop loss rules on any play to avoid that big loss that really hurts.
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