Cooking Tools #4: Cup and Handle Bases

A useful tool that traders use to determine when a stock is breaking out is the Cup and Handle (C&H) base. William O'Neill, the founder of the daily financial newspaper Investor's Businees Daily (IBD), was the first to coin the phrase in his book How to Make Money in Stocks which is a valuable resource that every serious investor should read. This chart pattern forms the basis of O'Neill's CANSLIM method. It's a proven method of identifying stocks that are breaking out and one that deserves a closer look. If you're unfamiliar with this chart pattern, read on. My point here is to acquaint you with the pattern so that you'll know what to do should it arise in the chart of one of your stocks or if you see it while perusing the charts of others.

The Cup & Handle Pattern
The basic pattern looks like a rounded cup with a smaller handle and represents a triple top. The shape typically looks like a drawn-out, rounded U shape rather than a sharp V. You want to look at the overall cup shape since minor fluctuations within it are usual. The pattern can last anywhere from two months to two years, In general, the longer the cup takes to form, the stronger it will breakout. The usual correction from the top of the cup (point A on the chart below) to the bottom (point B) typically varies from 12%-33%. Downturns greater than that suggests that there is something fundamentally wrong with the stock and should be regarded with caution. The left side of the cup is accompanied by an overall decrease in volume (there may be the occasional volume spike in there due to some sort of news) , and the right side of the cup is formed on gradually increasing volume (point C).

The handle is formed after the base is completed where the price returns at or close to the left side of the cup. Traders see that the price is returning to its resistance level and begin exiting their positions, thus forming the right side of the handle (C to D on the chart). Note that the volume decreases during this period. You should note, too, that the bottom of a true handle should never be more than the low point of the base. It's okay if the right side of the cup is lower than the left side, but if it's too much lower, then the subsequent breakout needs to be stronger. The recent daily chart of Volterra Semiconductor (VLTR) illustrates the cup and handle pattern.

How to play it: On daily charts, handles typically take one to two weeks to complete their formation. The way to play this pattern is to wait until the handle has formed and the stock breaks the high point of the cup's right side (point C) or what O'Neill terms the pivot point. This breakout must occur on heavier than normal volume (at least 50% heavier) for it to be a compelling buy. If the stock breaks out on mega-volume, this is a signal that institutions are pouncing on it and you should be, too.

Caveats:
1. You may have been patiently following the stock and noting its pattern, but it is foolhardly to buy the stock before it reaches its pivot point. Why? Many stocks just do not make it back to their pivots and end up declining in value. You need to wait for the stock to prove its strength before jumping in.
2. Many stocks breakout without ever forming handles. A handle isn't completely necessary but stocks that form cups without handles are more prone to failure.

Ways to play it: When you see a handle forming, set a price alert at the pivot. When the stock hits that point, you can do any of the following:
1. Buy the stock by entering a quarter or a third of your intended position at the breakout. Wait several days or weeks to gauge the strength of the price movement. If the general trend of the stock is up, keep adding to your position on price dips (such as when it hits a supporting moving average).
2. Buy call options in increments mentioned above. You can also sell out-of-the-money puts to finance your calls.
3. Call ratio backspreads. This is a fancy term for an easy concept. Here, a lower strike call is sold (usually at a strike close to the pivot point) and two (or more) higher strike calls are purchased. I won't get into the details of this strategy here, but I wanted to mention it because it's a favorite of many options traders who use it to play breakouts. The beauty of this strategy is that it sometimes can be put on for a credit (or a very small debit) while minimizing margin. Should the stock move a lot in either direction, a profit is realized (if the stock was put on for a credit). Even if the stock doesn't move, the amount that one risks is usually less than if one had purchased the stock outright. If you're not familiar with this strategy, you can check it out using the options links on this page.

As always, it's prudent to paper trade any of these strategies for a few months before putting your own hard-earned cash on the line. For more information, check out Investor's Business Daily and Bill O'Neill's book. IBD has daily charts that include stocks that are currently forming cup and handle bases.

Day-trading C&H patterns: The cup and handle pattern isn't just the province of long-term investors; many day-traders use this pattern on five minute or even one minute charts. Usually when a stock makes a dramatic climb at the beginning of the day, it spends several hours testing its new level. This is when you might see a cup and handle form. If the overall market is still trending up, the stock may make a breakout late in the day. Sometimes the stock will break out right before the close. This is a good time to buy as the odds favor a strong breakout gap when trading resumes the next day.