Cup And Handle Pattern Trading Strategy (Backtest And Example)
Last Updated on October 26, 2022
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:
|#Formations among 500 stocks from 1991 to 1996||391|
|Reversal or consolidation||302 consolidations, 89 reversals|
|#False signals||102 (26%)|
|Average rise of successful formations||38%|
|Most likely rise||10 to 20%|
|#Formations that reached the target||151 (49%)|
|The average length of the formation||208 days|
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.