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Your Cup of Tea

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Did you ever wish you could discover a new chart formation, one that proves more reliable than some of the others have over the last year? This article won't be about a new formation, but it will perhaps introduce some new ideas about an old one: the cup-and-handle formation. In a recent article on this formation in STOCKS AND COMMODITIES, technician Giorgos Siligardos discussed the pattern and brought up several points worth considering.

First, a review of the pattern might be appropriate. Although one of the charts used to illustrate Siligardos' description of this formation showed prices moving down just before a cup-and-handle formed, most consider these continuation patterns, and Siligardos' charts of actual price patterns suggest that, too. These form when prices have run up and hit resistance. If a cup and handle is going to form, prices then drop back in a rounding or cup formation and eventually rise back to the lip of the cup again. A second and smaller pullback forms the handle of the cup.

Annotated Weekly Chart of the DJUSHB:

Siligardos, at least, doesn't consider the handle a necessary part of the formation, but volume and other conditions must be watched if a handle does form. In fact, technicians have long warned that several conditions should also accompany the formation of the cup. First, there should be a trend to be continued. A cup-and-handle that forms after a long sideways action may not be as predictive of further upside as one that forms after a climb.

Both Siligardos and other sources emphasize that the cup should have a rounding bowl-shaped curve rather than a V-shape. While the DJUSHB formation was seen on a weekly chart, these can show up on daily and intraday charts as well, but the bowl's rounding shape should be appropriate to the time interval being watched.

In addition, ideally the cup will not retrace more than a third of the previous rally, some sources suggest. Some would consider a 38.2 percent Fibonacci level to be appropriate for a pullback, too, and one source notes that individual stocks or indices may differ in the way they form these cup-and-handle shapes. Some may typically retrace more than a third.

Volume considerations prove important. Volume should be high as prices move up to the left lip of the cup, drop off as prices drop back to form the bowl, and then rise again as prices move back toward the right lip of the cup.

If a handle is to form, similar volume considerations prove important. The handle's pullback should be short in duration--Siligardos sets the limit at 30 bars for the time interval he's watching--and volume should also drop off during the pullback that forms the handle, then explode as prices finally break above the lip. Most believe that the pullback should be shallow as well as occupying a short time frame, with many suggesting that the pullback should not take prices lower than one third the depth of the cup. Additionally, Siligardos believes that these formations tend to perform better if prices surge above the lip of the cup before falling back into the handle.

Something is wrong if the pullback that forms the handle is sharp, long in duration compared to the size of the cup or accompanied by strong downside volume. Be wary if that's what you see.

Confirmation comes when prices move back above the lip level after forming the handle, and when they do it on strong volume. After this confirmation, a price target can be found by adding the depth of the cup to the lip's price value. The DJUSHB example would have had an upside target of about 60 points, depending on how many candle shadows were included at the bottom of the cup and the level at which a trader judged the lip to be. If that lip were at about 697, the upside target would have been 757, a target that the index more than exceeded. Note that there was, however, a many-week consolidation just after the index had pushed through that target.

The question of how many candle shadows to include when setting the target leads into one of the salient points Siligardos makes. The choice of a candlestick or line chart might impact whether a trader perceives a cup forming at all. So does the choice of a semi-log or arithmetic chart. Siligardos suggests that semi-log charts be used, adding the comment that a cup shape on a semi-log chart will always look like a cup on an arithmetic chart, but that the opposite is not always true. A trader watching only arithmetic charts might not see the cup as it was forming.

Traders interested in these formations don't have to rely on what they see, however. Those using Metastock can incorporate Siligardos' program for recognizing these formations as they're building. You'll find the program and Siligardos' cautions about its shortcomings in the February issue of STOCKS AND COMMODITIES.

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