American entrepreneur William J. O’Neil defined the cup and handle (C&H) pattern in his 1988 classic, "How to Make Money in Stocks", adding technical requirements through a series of articles published in Investor’s Business Daily, which he founded in 1991. O'Neil included time frame measurements for each component, as well as a detailed description of the rounded lows that give the pattern its unique tea cup appearance. (To learn more, see: Analyzing Chart Patterns: Cup And Handle).

O’Neil pointed to four stages in a cup and handle breakout:

  • The security posts a significant high in an uptrend that accelerated between one and three months prior.
  • The next breakout attempt fails at the prior high, yielding a secondary pullback that holds near resistance, grinding out a smaller rounding bottom, which becomes the "handle".
  • The security returns to resistance for the second time and breaks out, yielding a measured move target equal to the depth of the cup.

Many cup and handle traders adhere strictly to O'Neil’s rules for construction, but there are many variations that produce reliable results. In fact, modified C&H patterns have applications in all time frames, from intraday scalping to monthly market timing. Finding and trading these updated versions requires an understanding of crowd psychology at contested price levels, as well as a trained eye that can see through higher noise levels that result from electronic stop running in the modern marketplace.

Deconstructing the Cup and Handle

Let’s consider the market mechanics of a typical cup and handle scenario. A new rally prints high and  the price rolls over into a correction, flipping relative strength oscillators into sell cycles that encourage strong-handed long to exit positions. (For more information, read: Use Weekly Stochastics To Time The Market Effectively). New buyers enter the pullback at the 38.6% or 50% retracement level, expecting the prior uptrend to resume. The security bounces and tests the high, drawing in aggressive short sellers who believe a new downtrend will elicit a double top breakdown.

That recovery swing may end at the old high or exceed it by a few points and then reverse, adding downside fuel because it traps two groups of buyers. First, longs entering deep in the pattern get nervous because they were betting on a breakout that fails. At the same time, longs chasing the breakout watch a small profit evaporate and are forced to defend positions. Both groups are now targeted for losses or reduced profits, while short sellers pat themselves on the back for a job well done. (On a related note, see: How Market Psychology Drives Technical Indicators).

The tables turn once again when the decline stalls high in the broad trading range, giving way to narrow sideways action. Short sellers lose confidence and start to cover, adding upside fuel while strong-handed longs who survived the latest pullback gain confidence. Relative strength oscillators now flip into new buy cycles, encouraging a third population of longs to take risk. A positive feedback loop sets into motion, with price lifting into resistance, completing the final leg of the pattern, and breaking out in a strong uptrend. 

Deconstructed mechanics tell us to look for the C&H pattern in places that William O'Neil never imagined, including 60 minute and monthly charts, because crowd psychology exhibits fractal properties, acting out similar emotional behavior within larger and smaller time frames. It also suggests that rounding bottoms aren’t needed as long as other structural elements draw in new buyers while short sellers get discouraged and cover positions. (To learn more, see: How To Read The Market's Psychological State).

With that in mind, let’s look at three cup and handle patterns that don’t fit the classic mold.

Multiyear Cup and Handle

Wynn Resorts (WYNN) went public on the Nasdaq exchange near $11.50 in October 2002 and rose to $164.48 five years later. The subsequent decline ended within two points of the initial public offering (IPO), far exceeding O’Neil’s requirement for a shallow cup high in the prior trend. The subsequent recovery wave reached the prior high in 2011, nearly four years after the first print. The handle follows the classic pullback expectation, finding support at the 50% retracement in a rounded shape, and returns to the high for a second time 14-months later.  The stock broke out in October 2013 and adds 90 points in the following 5 months.

Cup and Odd Handle

 

Microsoft (MSFT) printed two non-traditional cup and handle patterns in 2014. It topped out at $41.66 in April and pulled back to the 38.6% retracement of the last trend leg. Price carved out a choppy but rounded bottom at that level and returned to the high in June. It then grinded sideways in a consolidation pattern (1st blue box) that lasted for more than 5 weeks, or close to half the time it took for the cup segment to complete.

According to O’Neil’s description, the handle should extend no longer than between one-fifth to one-quarter of the cup’s length. This handle looks nothing like the ideal pattern but serves the identical purpose, holding close to the prior high, shaking out short sellers and encouraging new longs to enter positions. Note that a deeper handle retracement, rounded or otherwise, lowers the odds for a breakout because the price structure reinforces resistance at the prior high. (For additional reading, check out: The Anatomy Of Trading Breakouts).

The security finally broke out in July, with the uptrend matching the length of the cup in a perfect measured move.  The rally peak established a new high that yielded a pullback retracing 50% of the prior rally, nearly identical to the prior pattern. This time the cup prints a V-shape rather than a rounded bottom, with price stalling under the prior high. It grinded sideways in a broadening formation (2nd blue box) that looks nothing like the classic handle for another 3 weeks and breaks out. This rally failed to reach the measured move target at 50, calculated by adding the 4 point depth of the cup to the resistance line near 46.

Intraday Cup and Handle

The 60 minute cup and handle pattern offers an excellent timing tool when looking to buy a larger scale trend that doesn’t show a low risk entry price on the daily or weekly chart. Akamai Technologies (AKAM) consolidated below $62 after pulling back to major support at the 200 day EMA. It returned to resistance in early February and dropped into a small rectangle pattern with support near $60.50. This rectangular handle holds well above the 38.6% retracement level, keeping bulls in charge, ahead of a breakout that exceeds the measured move target and prints a 14 year high.

The Bottom Line

William O'Neil's strict requirements for the cup and handle pattern more than 20 years ago can be now expanded into various market scenarios in multiple time frames. This broader view allows us to pay less attention to the classic pattern’s standard definition and attention to crowd psychology that underpins its power to predict sizable breakouts. 

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