The cup-and-handle pattern is aptly named because it resembles a teacup with a handle.
On a stock chart, the cup appears as "U" shape. The handle appears as if it had the shape of a backslash symbol or "\".
The cup and handle is a bullish continuation pattern. It is marked by a consolidation, followed by a breakout. Once the pattern is complete, the stock should continue to trade upward, in the direction it was previously heading.
You can spot the pattern by looking for two main parts: the cup and the handle.
Within the cup, there are three components: the left side, bottom, and right side.
The left side of the cup is marked by a downward sloping arch. This part of the pattern represents the stock's temporary pullback. The pullback occurs because as the stock tests old highs, selling pressure increases. The bulls want to protect their profits. The bears want to push the stock price down. Ultimately, the bears win out. As the stock falls, trading volume tends to decrease.
This trading activity generally shows as a slight dip on the chart, or a rounded bottom. Volume is typically light. The sideways-like trading activity may last for approximately four days to one month. The longer and more pronounced the cup bottom, the stronger the buy signal once the final pattern has formed. However, cups with very deep bottoms or "V" shapes show sharp reversals and should likely be avoided. The ideal cup bottom is one-third the height of the previous advance.
The right side of the cup is the upward sloping arch, which indicates the stock's reversal back to the upside. At this point, the bulls have largely regained control. Volume generally increases as the stock moves back toward its old high. It can take a little as a month and a half for this part of the pattern to form. The more even the highs on both sides of the cup, the more reliable the pattern.
The handle always forms off the right side of the cup. It signifies that a small pullback occurred before the stock's ultimate rally. The handle may be marked by a pennant-like shape). The handle should, ideally, retrace one-third, or less, the height of the cup's advance. The smaller the retracement, the more bullish the breakout is likely to be. The handle usually forms within one week to a month. As the stock breaks out above resistance marked by the handle, volume typically increases. A breakout from the handle likely signifies a continuation of the stock's rally.
To determine how high the stock is likely to go after it has broken out, you can apply the measuring principle for a cup-and-handle formation. To do so, subtract the distance from the right peak of the cup to the bottom of the cup. Then, add this difference to the breakout level. This final number is your price target.
The six-month weekly chart of this week's stock pick Altera (Nasdaq: ALTR) provides a good example of the cup-and-handle formation.
From May to June, ALTR consolidated, in an approximate $3 range between $21.97 and $24.91. The stock's May 24 low of $21.97 marked the dip, or bottom of the cup. Note the gentle "U" shape that forms from this trading activity. Trading volume was average.
In mid-June, shares gained some strength. The bulls appeared to have again seized control. As the stock rose, the right side of the cup formed. Note how the right side of the cup almost perfectly matches the left side.
The handle formed between June 21 and 28 as the stock pulled back slightly. Because the retracement of the handle was less than one-third of the cup, the resolution should be bullish.
During the following week the handle was bullishly broken. The stock surged nearly $3 and closed the week at a new recovery high.
Spot the cup and handle pattern and drink to your trading profits.