Technical Analysis (Lesson Two): The Cup Pattern

The cup pattern is the most frequently mentioned of all bull-market patterns, but in practice it is one of the hardest to find examples of. To understand and apply it, we must first understand its essence. The biggest pitfall in learning technical analysis is getting caught up in appearances: using a mass of obscure definitions or labels to obscure the essence. Ultimately, technical analysis is simply a system made up of price and volume; a single system by itself does not constitute a reason to buy or sell. Only by understanding the more fundamental principles can it be used alongside other systems to complete a series of successful trades.

The original criteria for a cup pattern are: 1) It occurs after a weekly uptrend; 2) after reaching a resistance level or target price, a semicircular consolidation develops—that is, a relatively balanced progression from increased selling to equilibrium between buying and selling, and then to increased buying. In essence, this is a successful absorption of gradual distribution; 3) successful absorption of distribution means that price and volume diverge. Normally, price rises as volume increases and falls as volume decreases. In a semicircular consolidation, however, volume increases during the first half of the decline and decreases during the second half of the rise. As a result, the bottom of the semicircle—the base of the cup itself—is actually where trading volume is greatest across the entire pattern; 4) after returning to the previous high, the breakout fails: following the semicircular consolidation, price does not break above the previous high, but also cannot fall below the previous high by 5% or 1.5 ATR. This prompts holders whose reason for holding is a bet on another breakout, and whose willingness to hold is relatively weak, to sell quickly in anticipation of the failed breakout. The ensuing decline along a downward slope forms the left half of the cup handle, and the point where the price fails to break above the previous high becomes the handle's top. Here, too, the traditional price-volume divergence appears: this decline should occur on increased volume; 5) finally, support is found above the earlier cup bottom, completing a volume-backed rise consistent with price and volume moving together. Buy when the price breaks above the top of the cup handle.

The underlying structure of the entire pattern is actually an atypical rectangular consolidation range. What makes it atypical is that 1) it differs from the traditional price-volume divergence during rises and declines, and 2) the buy point is an aggressive entry in a rectangle pattern—that is, buying before price formally breaks above the top of the rectangular range.

The first high after the uptrend—the left endpoint of the cup itself—is the upper boundary of this rectangular range;

The bottom of the cup itself is the lower boundary of this rectangular range;

The right endpoint of the cup itself, also known as the top of the cup handle, marks the first failed attempt to break above the upper boundary and forms a key resistance level;

The lowest point of the handle lies above the earlier cup bottom, representing a failed attempt to break below the lower boundary of the rectangle. This is where the first buy point appears: the nontraditional cup-pattern buy point. In other words, one can buy as soon as a high-volume bottom fractal appears. The stop-loss level is the lower boundary of the rectangle, or the earlier cup bottom. This is an aggressive entry that requires a longer wait but carries lower stop-loss risk.

Buying when the right half of the handle breaks above the top of the cup handle is the second buy point, or the traditional cup-pattern buy point. In essence, it is the first buy point on a normal breakout from a rectangular consolidation: an entry at the key resistance level below the upper boundary. (The second buy point in a breakout from a rectangular consolidation is the upper boundary itself, or the left endpoint of the cup.) The stop-loss level is the handle's lowest point, which is the first, nontraditional cup-pattern buy point. This is a conservative entry with a relatively shorter wait, but greater stop-loss risk.

Because the top of the cup handle must not exceed the highest point on the left side of the cup itself, this reflects a short-term slowdown in the uptrend. In a bull market, this situation is rare during the first pullback in the leading sectors of the first tier, because they tend to make new highs. Thus, during the first pullback in a bull market, cup-and-handle patterns tend to appear in second-tier sectors that are following the leaders. The issue is that second-tier sectors have limited upside potential to begin with, so the risk-reward ratio is generally only moderate. This is the fundamental reason why backtesting a pattern without distinguishing its market context can produce very poor results. No pattern can be considered apart from the broader market context.

When trading A, you cannot look at A alone; you need confirmation from at least B or B+C. Without confirmation, there is no pricing anchor.

During the second pullback in a bull market, cup-and-handle patterns will appear in the leading sectors of the first tier. The portion that has genuine trading value is the one that occurs in this market context.