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 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).
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.
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.