The stock market has been climbing new levels in quick time. Several stocks have hit 52-week highs and several others are reversing their downtrend, forming interesting chart patterns. This week, we look at a chart pattern that many traders are familiar with — cup and handle. We discuss whether you should setup futures position or options position to trade this pattern. Also, we show how to determine the price target and the stop-loss before you initiate the trade.

Bullish strategy

A cup-and-handle pattern is a high probability bullish strategy. That means the strategy is likely to provide gains more often that it is likely to fail. Note that this still leaves room for the pattern to fail, leading to losses. This pattern is not difficult to identify on a price chart. The underlying will typically follow a u-shaped bottom and move upwards to the level from which it initially declined. This forms the rim (the top) of the cup. Thereafter, the underlying declines somewhat to create a pattern that looks like a handle of the cup. 

Given that this strategy has empirically been a high probability trade, you could consider setting up long futures position on the underlying. This is because futures will provide almost a one-to-one movement with the underlying, helping you maximise gains based on your view of the underlying. A long position is typically initiated when the price breaks above the top (rim) of the cup after it forms the handle. Before initiating the trade, you must determine whether it offers you at least a 2-to-1 reward-to-risk ratio. That is, for every two points of potential upside, you must not take more than one point of risk, determined by your stop-loss level. 

Your price target can be determined using a price measure rule. You must first determine the distance between the base of the cup (the horizontal line where the stock takes U-shaped turn) to the top (rim) of the cup. Then, take 61.8 per cent of this distance. Suppose the underlying formed a base at 400 and a top at 600. The total distance is 200 points. You should take 61.8 per cent of this distance, or 124 points. Add 124 points to 600 to arrive at a price target. After the underlying hits 600, suppose it declines to 550 before breaking 600 again. Then, your stop-loss must be preferably one point below 550. Note that 550 would be the bottom of the handle. Your upside potential is 124 points, and your downside risk is 50 points, offering 2.5-to-1 ratio.

For options traders
If you are more comfortable trading options, then you must consider buying an immediate OTM call just before the underlying breaks above the cup’s rim after forming the handle
Optional reading

If you are more comfortable trading options, then you must consider buying an immediate out-of-the-money (OTM) call just before the underlying breaks above the cup’s rim after forming the handle. The objective is to buy the option at a lower implied volatility, as the option price could increase sharply once the underlying breaks above the cup’s rim.

The author offers training programmes for individuals to manage their personal investments

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