Section 5:
Bullish Continuation Patterns
Cup and Handle
Definition:
The cup and handle is a unique bullish continuation pattern. It starts after a stock stages a lengthy rally. The stock then pulls back and starts to level off. The stock then rallies back up to the point at which the previous run ended. The stock reverses once more from the same level, creating horizontal resistance. The stock levels off after pulling back, attracting buyers, but this time at a relatively higher price. It returns to the horizontal resistance once more and breaks out, continuing its bullish trend.
Nuance:
The cup and handle is an extremely strong bullish continuation pattern. But unfortunately the pattern is rare. The strongest cup and handle patterns are usually long-term in nature, taking months or even years to form. Generally the longer the pattern takes to form, the strong it is once broken.
Application:
A cup and handle is confirmed when the stock breaks above horizontal resistance. Like other bullish continuation patterns with horizontal resistance, the cup and handle horizontal resistance often acts as support after it’s broken.
A cup and handle is violated if a stock pulls back from horizontal resistance and falls below the second low, creating a relatively lower low.
Figure 5.5
Example:
Shares of Deere (DE) traced a cup and handle, starting with the termination of a rally at the $44 level as shown in Figure 5.5. The stock then retraced down to near the $34 level, rounded out a bottom, and then headed higher back to $44. The stock pulled back for a second time from horizontal resistance at $44, but to a shallower level at $42. DE then returned to $44 a last time, breaking the resistance in spectacular fashion.
Observe how DE retested the $44 resistance level several weeks after breaking out from the cup and handle pattern. The stock surged higher in a short period of time after the successful retest of previous horizontal resistance at $44.
Bullish Continuation Patterns Summary
Bullish triangles, wedges, flags, pennants, and cup and handles are the most important price patterns to learn. The reason is simple: Stocks tend to move higher most of the time. Not all of the time. Not every time. But stocks tend to move higher a good portion of the time. Furthermore, stocks can go exponentially higher, but they can only fall to zero. This means the potential rewards from buying stocks far outweigh the potential rewards from shorting stocks.
There will, however, be periods in the market when it doesn’t make good trading sense to play bullish continuation patterns. Trading only bullish continuation patterns during bear markets, for example, is a bad idea.
There will be periods when the long-term upward flow of the market is interrupted. These periods are known as bear markets. They are rare in the broader market, as defined by the S&P 500, for example. Bear markets are more common in sectors and individual stocks. The next section details price patterns that are highly profitable in bear markets.