Among the eight principal base patterns — including the flat base, double bottom, saucer, base on base, ascending base, IPO base, and high, tight flag — the cup with handle remains to this day one of the most successful.
Why? Simple. Over the centuries, human nature hasn't changed. Greed, fear, hope, despair and other emotions drive stock prices. So do the laws of supply and demand.
This is why sifting through the charts of the market's greatest winners is time well worth spent.
As you'll see, the general shape of the cup with handle and other critical chart patterns appear over and over again. That's why they give the prepared investor an edge in the stock market. (You can sift through more than a century of history among the greatest stock market winners by going to the fourth edition of William O'Neil's classic, "How To Make Money In Stocks," and studying Chapter 1.)
So let's dissect this base. This is something you should know inside out. You need to know if that cup with handle is as it should be, or if it has flaws.
Basic Characteristics
The stock needs to show a 30% uptrend from any price point, but it must be before the base's construction. Or, the stock must show a minimum 20% increase from a prior breakout.
The cup with handle must be at least seven weeks long. If there is no handle, then the cup itself must stretch a minimum six weeks.
The handle alone needs at least five days to form, but it could go on for weeks. Make sure it doesn't exceed the cup portion in time or size of decline. A good cup with handle should truly look like the silhouette of a nicely formed tea cup. The handle always shows a smaller decline from high to low; it represents a final shakeout of uncommitted holders, sending those shares into sturdier hands in the market.
In most cases, the decline from high to low should not exceed 8% to 12%. During bear markets, some good cup with handle bases show a large, double-digit decline within the handle. But again, it should not exceed the drop within the cup.
The handle usually begins with a down day in price. Be aware that the handle itself, which must stretch for a minimum five trading sessions, can morph into a base of its own in certain cases. That's not a problem; it's often a stock's way of offering a buy point that's clearer or lower than that suggested by the larger pattern.
Must Be High Enough
The handle should form in the upper part of the entire pattern. If it's too low, it's flawed.
One way to check if that handle is proper: use the simple midpoint test. Add the highest price and lowest price within the handle and divide by 2. That number should be greater than the midpoint of the actual base itself.
Let's take the cup with handle fashioned by Baidu (BIDU) (see the chart below) in 2007. In the cup base, the high was 134.10 and the low was 92.80. Add the two prices together and divide by 2 and you get a base midpoint of 113.45. The handle showed a high of 132.80 and a low of 120.25, and its midpoint of 126.53 easily exceeded the cup's midpoint.
The handle should also show a downward slope along at least a portion of its price lows, not an upward one.
An upward-sloping handle is flawed; it represents weak demand as new buyers move into the stock at a trickling pace. During the stock's actual breakout, you want to see a new wave of buyers coming in at a torrid pace, not a trickling one.
Also, a steep, high-volume decline should put you on alert. You don't want to buy a stock that institutional investors couldn't wait to unload at any price.
The cup should form smoothly, without major price declines on the left side. Sharp gains on the right side aren't necessarily good, either. You might think that the opposite of a panic-driven exit would be a good thing. Likely not.
Avoid Deep Bases
Try to limit your picks to cups that are no more than 30% or 33% deep, except for those built during a bear market. In that case, an exceptional growth stock can fall 40%, 50% or more and still make a successful breakout.
Still, shallower is better. It shows that the big hands are catching the stock.
Look for volume to dry up along the lows of the base. Volume should be light in the handle, too.
Tighter price action is better. This is true of almost all bases. A loose, choppy base shows the stock needs to go far for price discovery. If institutions are holding on to the stock, it won't fall too far.
The Buy Point
This, of course, is where all the above parameters lead if they appear correctly. The buy point from a cup-with-handle base appears at the highest point of the handle, plus 10 cents.
In the case of former big winner Baidu, the proper buy point during its May 14, 2007, breakout was 132.90, a dime above the handle's intraday high of 132.80.
Less than six months later, the leading Chinese web search engine rocketed to 428, up 222%.
Volume On The Breakout
Even if all other parameters come together, you should avoid stocks that break out below their 10-week moving average.
Also, when the stock is breaking out, you should generally see a rush in turnover. Volume should ideally rise at least 40% above its 50-day average. For small and midcap stocks, expect breakout volume to double or triple.
The daily and weekly charts at both Investors.com and MarketSmith make heavy turnover easy to spot. Simply compare the day or week's volume with the moving average line drawn across the volume bars. An Investors.com chart will also tell you in real time how volume is running in comparison with typical level at that time of the trading session.
For the weekly chart, the moving-average line traces 10 weeks' worth of turnover.
What should you do if volume on breakout day is much lighter than usual? Sometimes volume will pick up in the next few sessions. Light volume in the market in general may also be a factor. Also consider that the breakout may have started later in the day.
O'Neil has often said at past IBD seminars that after a stock breaks out, he wants to see weekly volume rise vs. the prior week. This signifies a sudden shift in demand for shares that could continue to build up.
Are quarterly results coming up? If so, traders often hesitate before the news. But if the stock fails to make much headway in price, the relative strength line is fading, and the market itself is not showing positive action then something may be wrong with the timing of the breakout.
At that point, it makes sense to exit the stock, even if the 7%-8% loss-cutting sell rule has not yet been triggered.
(Editor's Note: A shorter version of this column originally published in the July 9, 2010, edition of IBD.)
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