The Cup and Handle Chart Pattern | Trading Strategy

Introduction

In this article i’ve already explainend what the Cup and Handle pattern is and how you can recognize the pattern. In this second article we will have a look at the different elements of a trading strategy based on this chart pattern.

From the previous article we know that the Cup and Handle pattern is a bullish continuation pattern. The pattern - once completed - offers opportunities to go long and speculate on a further price rise. As an example, we take the chart of the Edwards Lifesciences Corp. stock on date of June 09, 2021 in which there is a Cup and Handle pattern since the end of May 2021.



Longterm Trend

Because we are referring to a bullish continuation pattern, it is important to always keep an eye on the long term trend of the stock. Before we can withhold the pattern above we need confirmation that the long-term trend of the stock is positive. The timeframe for determining the long-term trend depends on the timeframe on which you trade. In this example, we assume the daily chart on which the pattern is visible (this is also the timeframe on which we trade), the weekly charts are used for identifying the long-term trend.

Below is the weekly chart of the ticker EW showing the ChartMill Trend Indicator.



You can either put the ChartMill Trend as an overlay directly on the chart or as an indicator below the price chart. The interpretation is simple, green is positive, red is negative and gray is neutral. On the weekly chart above, we notice that the long-term trend is positive since the beginning of April 2021. So we have confirmation that the Cup and Handle pattern on the first chart is occurring in a long-term bullish trend. In other words, there is a green light to withhold the pattern for a potential longsetup. In terms of trading setups, there are two basic options for taking a position based on this pattern.

Entry Management

Option 1 - Long Entry during the breakout candle

The first option will involve entering the market at the time of the breakout. A conditional order will be entered into the market even before the breakout is visible.



However, the buy order will only be effectively executed if the price reaches the $98.24 level with a limit at $98.56. A buy stop order has the advantage that you only buy if the trend continues. The associated 'limitorder' condition offers the advantage that we are protected should the price suddenly open significantly higher, also known as a gap up. If we only place a buy stop @ market and the price unexpectedly opens 10% higher the next day, our buy stop order will be executed at this high price.

The stoploss is placed below the second part of the chart pattern (below the 'Handle'). This is a fairly large stoploss as this setup speculates on a breakout above the existing resistance which, however, has not yet occurred.

Option 2 - Long Entry after the breakout candle is visible.

For option 2, we wait until the breakout has effectively occurred. An order is then set up for the next trading day.

With a high at $99.95, we do not want to enter the market until the price effectively breaks through the $100 barrier. We set a buystop limit order at the price level $100.03 with a limit at $100.50.



For the stoploss in this case we want to take into account the volatility of the stock and is therefore based on the ATR indicator. At the time of the break-out the ATR indicator is quoted at 1.89. For the initial stoploss, we use at least 2 times the ATR value which is then subtracted from the purchase price. This comes down to 3.78. As a first stoploss we obtain $96.32 ($100.1 - $3.78).

Exit Management

If the price evolves in a positive way, it is at least as important to protect the accumulated profits. For this too, there are several possibilities. Below we discuss 3 alternatives:

Option 1 - Price Target

For the active traders who like to know in advance where the position will be closed there is the possibility to use a predefined price target. By default 1 time the distance in height of the cup is taken.



Still, it's not a good idea to just adopt this as a standard. Much depends on the initial risk taken. If, for example, you use a first stoploss just below the 'handle' of the formation, in the best case you will end up with an R/R (Risk/Reward) of 2. If, however, you only take a long position after the break-out candle and then place a shorter stoploss below the break-out candle, in the same case you can count on an R/R of about 3 (for the same price target).

Option 2 - Swing Lows

This kind of exit management will sound familiar to trend traders. The stoploss is always increased on the basis of the last formed swinglow. The only disadvantage is that in case of strong increases with a lot of momentum, whereby no higher bottom is formed during a longer period, the stoploss can get quite far from the current price and therefore a considerable part of the accumulated profit is not protected. An example of this can be seen in the chart below in the green colored area. Suppose that after the green area no new high was formed, then the swinglow at the beginning of the green period would still be valid.


Tip: You can include in the chart an automated swing stop where ChartMill completely autonomously changes the stoploss after each trading day. More info in this article. Below an example of the swing stop on the chart of EW.



Option 3 - ATR based

Why the ATR is a good indicator for determining a stoploss, you could already read in this article. In short, the ATR is a volatility indicator, which takes into account the movement of a stock. If the share moves a lot, the ATR-based stoploss will rise less quickly than in case of calm and limited price fluctuations. Below an example with the ATR stop (chandelier exit).



Conclusion

  • Compared to other chart patterns such as 'the rising of falling wedge' it is quite easy to recognize this pattern on a price chart.

  • It is a simple pattern but certainly not less useful than other patterns. As with all patterns it is important to let the pattern develop fully before taking action. Personally, I only consider a position after the breakout from the pattern.

  • Those who prefer not to buy immediately after the breakout can instead opt to wait until a small price rebound. In the chart below you can see how after the initial breakout the price falls back a bit. A reversal pattern eventually forms. After this pattern is completed, one can enter the market. The price at which you then buy will not be lower in this case. The benefit here is that you can immediately place the stoploss below the swinglow of the reversal pattern.



Hopefully these two articles regarding the Cup and Handle pattern have brought some insight in what the pattern is all about and how you can build a trading strategy based on it. [In our documentation center](https://www.chartmill.com/documentation/chart-patterns) you will find a lot of information about other specific chart patterns such as the triangle pattern and the wedge pattern. Be sure to check them out!

The ChartMill Team