Introduction
Investor William J. O’Neil said that “Fortunes are made every year by those who take the time to learn to interpret charts properly.” This is accurate advice as he has made millions using charts to identify stocks when they were at ideal buying opportunity. One of the most common and probably the most important chart patterns is the cup with handle. The name comes from its shape when viewed from the side. This pattern has occurred in great market leaders throughout history and still occurs today. O’Neil found in his extensive historical stock market research that “history repeats itself. This is because human nature doesn’t change. Neither does the law of supply and demand. Patterns of the great stocks can be used as models for future selections.” Let’s go through the characteristics of the cup with handle pattern, how to spot it and at what point to buy when using it.
Pattern Features
First lets talk about the basic features of the cup with handle pattern. The ideal patterns looks like a coffee cup with a downward sloping line on the right hand side. The base of the pattern is the distance from its first peak (Left Cup) to the end of the handle. The official start of the base when counting its length is at the first week down in price after the peak. It’s end is when the price rises $ 0.10 above the high point of the handle (left end of handle). It’s a depth is measured in a percentage price change from first peak the lowest point in the base. This is generally referred to as its correction or how much the stock corrects.
Pattern Characteristics
According to O’Neil author of How to Make Money in Stocks the length of a cup with handle pattern can be anywhere from 7 to 65 weeks but it’s typical length is from 3 to 6 months. If the pattern is less than 7 weeks it’s not a cup with handle pattern. The pattern may correct anywhere from 12% to 33%. Less than 12% and it’s not a cup with handle pattern. Correction greater than 33% and it may still be a cup with handle patterns but use caution as this is a sign of weakness. The pattern should have a prior uptrend of at least 30% building up to the peak of the base. The bottom of the cup should be rounded like a U as opposed to narrow like a V. This shows that the stock is moving through its natural correction. During the U weak holders and speculators are shaken out and move on to other things. If the stock has good fundamentals the institutional holders will hang on during this time forming a good foundation for the stock.
Handle Characteristics
The handle should take more than one week to form and should trend downward shaking out the last remaining weak holders. Volume should dry up noticeably during the handle. The handle should form in the upper half of the base, this being measured from the peak of the base to it’s low. As well the handle should be above the stock’s 10 week moving average line. A bad characteristic of the handle is one that trends up in price along the low points if the daily price. As sideways trend is bad as well. These patterns have a much higher probability of the failing when they do break out. The correction during the handle should be 8% to 12% off its peak.
Tight Price Areas
A healthy characteristic of a cup with handle pattern is what O’Neil calls “tight price areas”. These are small variations in price from high to low for the week. This can be seen when looking at the stock’s weekly chart. Wide spreads in the price variation show that “the stock has been constantly in the markets eye and will frequently not succeed when it breaks out” according to O’Neil.
Watching the volume
On a proper cup with handle pattern the stock will charge through the buy point on very high volume. According to O’Neil the volume should increase at least 40% to 50% above normal. “It is not uncommon for new market leaders to show volume spikes up 200%, 500%, or 1000% greater than average daily volume.” This is a positive sign because it shows institutional buying which is what causes big advances in price. The easiest way to examine a stocks volume movement is by looking at daily charts. Charts can be viewed on free financial sites such as google.com or in financial papers like Investors Business Daily.
The Buy Point
The buy point for a cup with handle pattern is $0.10 above the prior peak. The reason we wait for it go above the handle is that we want to make sure it breaks through its prior level of resistance. Note that you do not want to wait until the stock crosses its absolute peak as this substantially increases your risk. To find you’re buy point use weekly stock charts to identify bases forming. Once you see a base emerging on a weekly chart switch to daily chart to identify the exact buy point. Look for the price to cross your buy point on above average volume. This significantly increases the chance of the breakouts success.
Conclusion
This should give you enough to start identifying cup with handle bases on stock charts. If you would like information on other common chart patterns check out my article on the Basics of Reading Stock Market Charts.
If your interested in an opportunity to learn from great investors check out Investors Quotes Daily. They send out a daily quote from successful investors such as Warren Buffett, Peter Lynch and William J. O’Neil. Sometimes it’s one of their investing strategies and other times a piece of sage wisdom. It’s a great way to get a daily does of what it takes to be a great investor.
