Cup And Handle Trading Strategy: (Backtest And Example) - Quantified Strategies (2024)

Chart pattern recognition is one of the most popular techniques employed by chartists and technical traders; they constantly study and analyze price movements in hopes of detecting patterns that show the next most probable price movement. While there are many different types of chart formations out there, the cup and handle pattern strategy is one you may want to add to your trading arsenal because of its reliability. Let’s find out what it is.

The cup and handle pattern strategy is a formation on the price chart of an asset that resembles a cup with a handle. It is a bullish continuation pattern that marks a consolidation period followed by a breakout.

As its name implies, the pattern consists of two parts — the cup and the handle. The cup looks like a “u” or a bowl with a rounded bottom that forms after a price rally, while the handle is a trading range that develops on the right-hand side of the cup. The pattern completes when the price breaks out from the handle’s trading range to signal the continuation of the previous rally.

In this article, we backtest the cup and handle pattern strategy. Because the cup and handle pattern is difficult to define with strict buy and sell rules, we refer to other research.

Let’s dive in to learn how to spot this pattern.

Cup with handle pattern

First, we want to write that the cup and handle pattern is also called cup WITH handle pattern. They are the same pattern and formation.

What is a cup and handle pattern?

The cup and handle pattern is a formation on the price chart of an asset that resembles a cup with a handle. As its name implies, the pattern consists of two parts — the cup and the handle. The cup has the shape of a “u” or a bowl with a rounded bottom that forms after a price rally, while the handle is a trading range that develops as a slight downward drift on the right-hand side of the cup. Further down in the article we have several charts to show how it looks like in a chart.

The pattern is a bullish continuation formation that marks a consolidation period, with the right-hand side of the pattern typically experiencing lower trading volume. The cup part of the pattern forms after a price rally and looks like a gradually rounded bottom of a bowl. As the cup is completed, a trading range develops on the right-hand side, which becomes the handle A subsequent breakout from the handle’s trading range signals a continuation of the previous price rally.

Thus, the cup and handle pattern is considered a bullish signal extending an uptrend, so technical traders and chart analysts use it to spot opportunities to go long.

The cup and handle pattern is pretty famous and known. One of the reasons for that belongs to William O’Neil. O’Neil is the innovator of the CANSLIM method and one requirement was that the stock must form some kind of a cup and handle pattern. O’Neil was, to our knowledge, the first to describe the pattern, in his 1988 bestseller and classic How to Make Money in Stocks. He has been adding technical requirements through a series of articles published in Investor’s Business Daily, which he founded in 1984. Following his principles, traders using the pattern should place a stop buy order slightly above the upper trendline of the handle part of the pattern.

What are the rules for the cup and handle pattern?

The criteria that qualify the cup and handle pattern include:

• The trend: Being a continuation pattern, the pattern must occur in an existing trend. But the pattern works best in a new trend, not an old one.
• The cup: The cup should have the shape of a “U” and resemble a bowl with a rounding bottom. It should never have a “V” shaped bottom, as that would be considered too sharp of a reversal to qualify. With a softer “U” shape, it shows a consolidation pattern with valid support at the bottom of the “U”. While the perfect pattern would have equal highs on both sides of the cup, it may not happen that way.
• The depth of the cup: The depth of the cup should be a retracement of 38% or less of the previous price rally. But in volatile markets, the retracement could be up to 50%, and in extreme situations, the maximum retracement could be up to 62% or 2/3, which conforms with Dow Theory.
• The handle: After the high forms on the right side of the cup, the price makes a pullback that forms the handle, which often resembles a flag or pennant that slopes downward. The handle represents the final consolidation/pullback before the big breakout. Its extent can be up to 1/3 or 38% retracement of the cup’s right side. However, the smaller the retracement, the more bullish the formation, and the more significant the breakout.
• The duration: This depends on the timeframe you are observing the pattern. Generally, the cup takes 10-26 periods to form, while the handle takes about 4 periods.
• Volume: There should be a volume decline during the formation of the pattern since it is a consolidation pattern, but the volume increases significantly on the breakout above the handle’s resistance.
• The breakout: The pattern completes with the breakout above the handle’s resistance line. But it may be better to wait for a break above the resistance line formed by the highs of the cup.

What does the cup and handle pattern look like?

Here is an example of a cup and handle pattern:

The cup and handle pattern is made up of two parts:

• The cup. The cup looks like a “u” or a bowl with a rounded bottom. It forms after a price rally, and its depth should be 30-50% of the rally preceding it. The shallower and more rounded the cup, the better the pattern.
• The handle. The handle is a trading range that develops as a slight downward drift on the right-hand side of the cup. When you look at the handle with the price advance that forms the right side of the cup, it looks like a flag or pennant.

The pattern completes only when the price breaks out from the handle’s trading range to signal the continuation of the previous rally.

Is the cup and handle pattern bullish or bearish?

The cup and handle pattern forms in an uptrend, especially a new uptrend. It is considered a consolidation in the uptrend, and the trend is expected to continue moving upward after the consolidation when the price breaks above the resistance of the consolidation.

Thus, the cup and handle pattern is seen as a bullish continuation pattern. When the price breaks above the trading range that forms the handle of the pattern, it is expected to also break above the resistance of the swing high of the cup and make a huge advance. When trading the pattern, it may be better to wait until the price breaks above the cup’s swing high.

What does an inverted cup and handle mean?

This is an inverted form of the cup and handle pattern that forms in a downtrend. As with the classical cup and handle platform, the inverse one represents a consolidation in a trend, but this time, in a downtrend. Being a continuation pattern, the inverted cup and handle pattern signals the continuation of the downtrend.

The inverted cup and handle pattern consists of an inverted cup and a handle. The inverted cup is like a dome with a rounded top and forms after a price decline, with the height about 30-50% of the decline preceding it. The handle is a trading range that develops as a slight upward drift on the right-hand side of the inverted cup. The pattern completes when the price breaks out from the handle’s trading range to signal the continuation of the previous rally.

What is a cup and handle reversal?

The cup and handle pattern and the inverted type are continuation patterns. Under normal conditions, they are not expected to signal trend reversals, but nothing is perfect in the market. There can be situations where, after the formation of the handle, the price breaks below the support level formed by the bottom of the cup, invalidating the pattern.

What are some cup and handle examples?

There are many examples of the cup and handle pattern you can find on your charts. These are some examples:

The chart above is that of Jabil Inc. in 1999. From the chart, you can see that the price formed a cup between June and October 1999. By November, it has formed a handle and eventually broke above the handle. What followed was a huge rally.

The chart above is a monthly chart of Wynn Resorts. You can see the cup and handle pattern that formed between 2005 and 2007. Notice how the price made a huge rally after that.

What is a double cup and handle pattern?

This is a situation where the price forms two consecutive cup and handle patterns. That is, two cups form in succession, followed by a handle. Here is how it forms: after the breakout above the handle of the first cup, the price rose and then created another handle, such that the first handle becomes a part of the second cup. The pattern completes when the price breaks above the handle of the second cup. The price usually makes a big rally after the breakout.

What does the cup and handle target mean?

The projected advance after breakout can be estimated by measuring the distance from the right peak of the cup to the bottom of the cup. You measure out the target from where the price breaks above the handle of the cup. See the chart below:

As you can see in the chart, the price reached the projected target before making a pullback. After the pullback, it continued to rally.

Cup and handle trading strategy (backtest)

So far we have only shown some anecdotal evidence of the cup and handle pattern. This site is all about quantified strategies and we only add a profitable trading strategy to our portfolio of trading strategies if it has strict buy and sell rules that is not left to discretionary judgment. We use Amibroker to backtest trading edges, and we have managed to write a script that detects the cup and handle pattern in a chart, but we don’t want to put in the time and effort to create backtest of the cup and handle pattern.

Unfortunately, it’s difficult to make a cup and handle pattern backtest. You need to add many variables and we are reluctant to spend time coding the strategy. Instead we refer to a backtest done by Ali Akhtari in an article called Trading Cup and Handles With MarketSmith Pattern Recognition published on gitconnected. To our knowledge, Akhtari ran the test on stocks in the S&P 500. The result of the cup and handle backtest from 2016 until 2018 was this:

• CAGR 9.7%
• Sharpe Ratio 1.27
• Max drawdown 4.9%
• Sortino Ratio 2.4

The cup and handle strategy underperformed S&P 500, but it shows good trading strategy metrics (considering the low exposure to the market).

Does the cup and handle strategy perform better in a wider range of stocks?

Let’s look at the results that Thomas Bulkowski revealed in his monumental The Encyclopedia of Chart Patterns, published in 2000. It’s a bit old, but technical analysis don’t change, right?

Thomas Bulkowski is an engineer and went through technical formations for 500 stocks over a period of five years. He registered, manually we must add, over 15 000 formations, and the cup and handle pattern strategy was one of those (he called it cup with handle pattern in his book, though).

We looked at the results from his manual cup and handle backtest and the results can be summarized in this table:

The failure rate is 26%, above the 20% that Bulkowski considers acceptable. However, if you wait for an upside breakout, the failure rate drops to 10% (not shown in the table above). Even the average gain of 38% is lower than Bulkowski likes to see (which is 40%).

Unfortunately, Thomas Bulkowski doesn’t give us any clear and solid answer on what kind of statistical expectancy you can expect by using the cup and handle strategy. Thus, we take his findings with a pinch of salt.

Cup and handle pattern strategy – ending remarks

We were not able to develop a 100% quantified cup and handle strategy. We looked at what others have backtested:

William O’Neil’s CANSLIM method shows better performance than the overall market (S&P 500) in backtests, even though it has lagged in recent years. Although we might argue O’Neil is the innovator of the cup and handle strategy, it’s just one part of many in his methodology. We can’t conclude on the profitability of the cup and handle strategy based on the CANSLIM method.

Thomas Bulkowski’s backtests are also lacking strict buy and sell rules, and he argues the cup and handle strategy is inferior to many other patterns.

How can traders identify the cup and handle pattern in different markets?

Traders can identify the cup and handle pattern in different markets by recognizing its distinct shape and understanding the underlying market psychology. The cup and handle is a bullish chart pattern that resembles a teacup with a handle, indicating a potential continuation of an upward trend. To spot this pattern, traders should look for a rounded bottom that forms the cup, which represents a consolidation period followed by a rise back to the previous peak. This peak forms the rim of the cup. After reaching this peak, the price undergoes a minor pullback that forms the handle, which is typically a downward drift with lower trading volume.

The handle should not dip below the half-way point of the cup’s depth, as it signifies a slight pause or consolidation before the price attempts to break out. The breakout occurs when the price moves above the resistance level marked by the rim of the cup. For validation, traders often wait for an increase in volume during the breakout to confirm the pattern’s strength and the likelihood of a continued uptrend.

In different markets, such as stocks, forex, or commodities, the cup and handle pattern can manifest over various time frames, from short-term charts to longer-term weekly or monthly charts. Traders adapt by adjusting their technical analysis tools and volume indicators to match the market’s characteristics and liquidity. Additionally, integrating other technical indicators like moving averages, RSI, or MACD can help confirm the pattern’s reliability and potential entry or exit points.

What are the key indicators that confirm a cup and handle pattern?

The key indicators that confirm a cup and handle pattern in technical analysis involve a specific chart formation that suggests a bullish continuation of a financial instrument’s price. This pattern is identifiable through several distinct characteristics:

1. The Cup: This formation resembles a rounding bottom and represents a period where prices initially decline, then bottom out, and finally start to rise again, tracing a U-shape. The depth of the cup typically suggests a consolidation phase that can last from several weeks to many months. It’s important that the cup forms with a slight downward drift rather than a sharp V shape, indicating a gradual reversal of the downtrend into an uptrend.
2. The Handle: Following the formation of the cup, a short pullback occurs, which forms the handle. This handle is a smaller retracement of the cup’s right side, usually not more than one-third of the cup’s depth. It should slope downwards slightly. The handle’s formation is crucial as it indicates the market’s last attempt to push the price down before the breakout. The handle should be shorter in duration than the cup, often lasting one to four weeks.
3. Volume: Volume plays a critical role in confirming the cup and handle pattern. Typically, volume is higher on the left side of the cup and diminishes slowly as the pattern progresses. A significant increase in volume should occur during the breakout from the handle, confirming the pattern’s strength and the potential for a bullish continuation.
4. Breakout: The confirmation of the cup and handle pattern is marked by a price breakout from the handle’s upper edge, preferably on higher volume. This breakout is the final indicator that suggests buyers have gained control, and the price is likely to continue its upward trajectory.

How long does it typically take for a cup and handle pattern to form?

The formation of a cup and handle pattern typically varies in duration, depending largely on the timeframe being analyzed and the specific market context. Generally, this pattern can develop over several months to over a year in daily or weekly charts, reflecting a consolidation period that gradually shapes the “cup” part of the pattern, followed by a shorter, often few weeks to a couple of months, consolidation period that forms the “handle.” The key is to recognize the rounding bottom of the cup, which signifies a period of accumulation and a gradual shift from a bearish to a bullish market sentiment, and then the handle, indicating a final shakeout of weak holders before a potential upward breakout. However, the exact time can significantly differ between stocks, commodities, or forex markets due to varying volatility and trading volumes.

What role do volume and price action play in the cup and handle pattern?

The role of volume and price action in the cup and handle pattern is pivotal for traders analyzing potential buy signals in the stock market. This pattern, which resembles the shape of a tea cup with a handle on its right side, serves as a bullish signal indicating a possible upward price movement. Volume and price action provide crucial clues during the formation of this pattern.

As the cup forms, which is the initial U-shaped curve, there’s typically a gradual decline in volume. This decrease suggests diminishing selling pressure, indicating that the downtrend may be losing momentum. When the price starts to recover, forming the right side of the cup, an ideal scenario would see a gradual increase in volume. This increase in volume during the recovery phase is a positive sign, suggesting growing buying interest and support for the upward price movement.

The handle forms immediately after the cup as a smaller downward drift in the price, resembling a slight consolidation or a flag pattern. During this phase, volume plays a crucial role once again. A decrease in volume during the handle’s formation suggests reduced selling pressure, which is a bullish sign. Importantly, for the pattern to confirm a breakout, a significant increase in volume is expected as the price breaks above the resistance level formed by the handle’s upper trend line. This spike in volume confirms the strength behind the breakout, offering traders confidence in the pattern’s predictive reliability for an upcoming price surge.

How can traders set stop-loss orders when trading the cup and handle pattern?

Traders can set stop-loss orders when trading the cup and handle pattern by first identifying the pattern’s key features. This classic chart pattern typically consists of a “cup” formation followed by a smaller “handle,” which signals a continuation of an uptrend. To mitigate risks and manage trades effectively, traders often place stop-loss orders just below the handle’s lowest point or the cup’s bottom. This strategy provides a safety net in case the anticipated breakout fails and the price begins to fall, ensuring that losses are limited. It’s essential to wait for the handle to form completely and for a breakout above its resistance level to confirm the pattern’s validity before placing the trade. Additionally, adjusting the stop-loss order as the price moves favorably can help to lock in profits and protect against sudden market reversals. This method balances the need for risk management with the potential for significant gains, making it a favored approach among those trading the cup and handle pattern.

What are the common mistakes to avoid when trading the cup and handle pattern?

The common mistakes to avoid when trading the cup and handle pattern include not confirming the pattern completely before initiating a trade. Traders often jump in too early, mistaking normal price fluctuations for the actual formation of the pattern. This premature action can lead to entering the market before the pattern fully forms, which increases the risk of the trade not playing out as expected.

Another mistake is ignoring the volume. The volume should decrease as the cup forms and increase significantly when the price breaks out from the handle. Overlooking volume patterns can lead to misinterpreting the strength of the breakout, potentially resulting in entering a weak trade.

Traders also sometimes set their profit targets and stop-loss levels inaccurately. The profit target for a cup and handle pattern is typically measured from the bottom of the cup to the pattern’s breakout point, added to the breakout level. Setting unrealistic profit targets or too tight stop-loss levels can cut profits short or result in unnecessary losses.

Additionally, neglecting the broader market context is a mistake. Even if a cup and handle pattern appears perfect, it’s crucial to consider overall market conditions. Entering a trade based on this pattern during unfavorable market conditions can lead to failed breakouts and losses.

Lastly, relying solely on the cup and handle pattern without considering other technical indicators and analysis techniques can limit a trader’s perspective. Using additional indicators for confirmation can help validate the pattern and increase the chances of a successful trade. Avoiding these common mistakes can significantly improve a trader’s success rate when trading the cup and handle pattern.

How does the cup and handle pattern fit into a broader trading strategy?

The cup and handle pattern fits into a broader trading strategy by serving as a bullish signal that can help traders identify potential opportunities for buying stocks or other assets. This pattern is characterized by a period where prices initially decline, then bottom out and start to rise again, forming what looks like a cup. The handle is formed by a smaller downward drift in prices following the rise, before another upward movement. Traders often view the completion of the handle as a confirmation signal to enter a long position, expecting that the asset’s price will rise following the pattern’s completion.

Incorporating the cup and handle pattern into a broader trading strategy involves several key considerations. First, traders should ensure that the pattern fits within the context of the market’s overall trend, as it is generally more reliable in bullish markets. Additionally, traders may use other technical indicators, such as moving averages or volume analysis, to confirm the pattern’s validity and to determine the optimal entry and exit points. This approach can help in minimizing risks and maximizing potential returns.

Furthermore, the cup and handle pattern can be combined with fundamental analysis to strengthen the trading strategy. By assessing the underlying financial health and potential growth of the company or asset in question, traders can better gauge whether the bullish signal provided by the pattern is likely to result in a sustained upward movement in prices.

Can the cup and handle pattern predict long-term market trends?

The cup and handle pattern can offer insights into long-term market trends, serving as a bullish signal in technical analysis. Traditionally identified on stock charts, this pattern is characterized by a ‘cup’ formation, which represents a period of consolidation followed by a breakout, and a ‘handle’, indicating a slight downward drift before a final upward trend. The cup section typically forms after a significant upward movement, reflecting a stabilization or minor correction phase, followed by a recovery that mirrors the initial rise to complete the cup shape. The handle is formed by a smaller pullback before the price continues to ascend, suggesting that the market is gearing up for a continued upward trajectory.

This pattern is predicated on investor sentiment and market psychology, representing a consolidation period that shakes out weak holders and demonstrates a strong buy-in from investors at the current levels before resuming its uptrend. While it’s a popular tool among traders for signaling potential bullish outcomes, it’s crucial to consider it within a broader market context, including fundamental analysis and other technical indicators, to enhance predictive accuracy.

Moreover, the effectiveness of the cup and handle pattern in forecasting long-term market trends can vary based on market conditions, the timeframe over which it develops, and the volume patterns during the formation. In practice, while no technical pattern can guarantee future market movements with absolute certainty, the cup and handle pattern provides a framework for identifying potential long-term bullish trends, assuming it’s complemented by thorough analysis and considered alongside other market factors.

How does market volatility affect the formation and outcome of the cup and handle pattern?

Market volatility significantly influences the formation and outcome of the cup and handle pattern, a widely recognized chart pattern among traders and investors. This pattern, characterized by its resemblance to a tea cup when viewed on a chart, typically signals a bullish continuation of an asset’s price. The “cup” part of the pattern reflects a period where the market undergoes a correction, followed by a stabilization and a gradual recovery back to its previous peak, forming a rounded, cup-like shape. The “handle” forms as the price undergoes a smaller, temporary pullback before resuming its upward trend.

The degree of market volatility plays a crucial role in the development and reliability of this pattern. In environments of high volatility, the cup and handle formation can be more erratic, making it harder to identify and potentially reducing its predictive accuracy. The sharp price swings associated with high volatility can disrupt the smooth formation of the cup and handle, leading to false signals or the pattern’s failure. For instance, a sudden market event could cause a sharp price drop or spike that deviates from the expected gradual recovery of the cup or the slight pullback of the handle, thereby confusing the pattern’s recognition.

Conversely, in periods of low to moderate volatility, the cup and handle pattern tends to form more clearly and predictably, thereby increasing its reliability as a continuation signal. The smoother price movements allow for a more defined and recognizable pattern, making it easier for traders and investors to identify and act upon. The outcome of a well-formed cup and handle pattern in such an environment is often a strong bullish breakout, as the market’s steadier conditions support the predictive nature of the pattern.

What are the psychological aspects behind the formation of the cup and handle pattern?

The psychological aspects behind the formation of the cup and handle pattern in stock trading charts are deeply rooted in investor sentiment and market psychology. This pattern, often seen as a bullish signal, is created through a series of market movements that reflect the collective behavior and attitudes of market participants. Initially, the “cup” forms as prices fall and then gradually rise back to the original level, mirroring a period of initial pessimism followed by a return to optimism. This phase represents a consolidation period where investors are reassessing the asset’s value, leading to a stabilization of price after a previous decline. The subsequent “handle” forms when prices dip slightly due to profit-taking or hesitation among investors, indicating a minor pullback or consolidation before a potential upward breakout.

The cup and handle pattern is a manifestation of the psychological tug-of-war between fear and greed, patience, and impulsiveness among traders. The initial drop in prices may trigger fear and lead to selling, while the gradual recovery reflects a growing consensus that the asset was undervalued, leading to increased buying activity. The formation of the handle signifies a final test of the asset’s stability and potential for growth, as investors who are more risk-averse may sell off their holdings, while those with a longer-term outlook may hold or increase their positions, anticipating future gains.

Overall, the cup and handle pattern encapsulates the market’s psychological cycle from pessimism to optimism, underscored by a collective reassessment of value and a test of investor conviction before a potential upward movement. This pattern underscores the importance of psychological factors in market dynamics, where patterns are not just reflections of past price movements but also predictors of future psychological states of market participants.

FAQ:

– What is the cup and handle pattern strategy?

The cup and handle pattern strategy is a bullish continuation pattern on a price chart that resembles a cup with a handle. It marks a consolidation period followed by a breakout, often indicating a potential upward price movement.

– What are the components of the cup and handle pattern?

The cup and handle pattern consists of two parts — the cup and the handle. The cup resembles a “u” or a bowl with a rounded bottom, forming after a price rally. The handle is a trading range that develops on the right-hand side of the cup.

– What are the rules for qualifying a cup and handle pattern?

The criteria for the cup and handle pattern include: occurring in an existing trend, forming a cup with a “U” shape, cup depth of 30-50% retracement, development of a handle, and a breakout above the handle’s resistance line.