Inverted Cup and Handle Pattern: A Guide for Stock Market Traders

Inverted Cup and Handle Pattern: A Guide for Stock Market Traders

Experienced traders already know that chart patterns can be useful for polishing one’s technical analysis. One noteworthy example of a bearish reversal chart pattern is the inverted cup and handle. It signals a precise point at which a stock price is likely to decline after a bullish rally.

This blog aims to break down this pattern for Indian traders and investors who have a basic understanding of the market. You will learn what the inverted cup and handle pattern is, how to identify and trade using it.

What is the Inverted Cup and Handle Pattern?

The inverted cup and handle pattern is a bearish reversal pattern. It typically follows an extensive uptrend on a stock price. At this point, the bears begin to overpower the bulls, forcing the stock price to reverse and head south.

The pattern resembles a teacup turned upside down. Initially, the price creates a rounded top (the inverted) capsule along with the cup, followed by small upward or sideways movement forming the handle. The bearish moves below the bottom support line after the handle completes creates a powerful bearish reversal signal.

Visualising the Pattern

To envision this shape, consider a hill. The price increases, then makes a rounded top like a dome before experiencing a slight rise or sideways movement and subsequently falling. That slight increase or sideways movement is the handle. The pattern is considered complete once the price drops below the handle's support zone with significant volume.

How This Pattern Forms

The inverted cup and handle pattern has three main parts:

• The Cup - After a strong rally upwards, the stock starts to lose momentum. It slowly forms a rounded top which suggests that strong buyer sentiment is running out of steam.
• The Handle - After forming the rounded top, the stock might experience a slight uptick or trade within a tight range. This movement is usually brief, thus forming the handle.
• The Breakdown - If the price drops below the support level (the base of the handle) after forming the handle, there should be increased volume to indicate strong selling pressure.

This pattern indicates that sellers are in control and the price is likely to continue declining.

Why Is This Pattern Important?

This pattern is significant because a trader could:

• Close long trades before prices plunge.
• Shift strategies for selling stocks.
• Anticipate a continuous downward trend.

Understanding the inverted cup and handle pattern sooner can save you from incurring losses and allow you to capitalise on price drops.

Trading Tactics for the Inverted Cup and Handle Pattern

It is time to break down how you can use this pattern as part of your trading strategies.

1. Identify the pattern

Look for the rounded top, your inverted cup. Now, look for a small rise or sideways movement on the right side of the cup. That’s your handle. Candlestick charts can assist you immensely here.

2. Validate with Volume

Make sure to verify whether the volume during the breakdown is on the rise. A breakdown with low volume can result in a negative outcome. The ratio of volume towards the breakdown adds value to the pattern.

3. Position of Entry

Take a short position (sell) once the price moves below the handle support. There is no need to be impulsive. Ensure that the price closes below the support level before confirming the pattern.

4. Loss Limit

Place a stop-loss slightly higher than the top of the handle. This is in case the pattern fails, and you want to limit losses.

5. Target Price

To set the target, measure the height of the cup (the distance from the top of the cup to the support level, the bottom of the handle). This value is then subtracted from the breakdown level to get your target.

For instance, the height is ₹50 if the top of the cup is ₹1000 and the support is ₹950. If the price breaks down from ₹950, your target will be ₹900.

Real-Life Example of the Pattern

Consider a scenario in which a stock rallies from ₹500 to ₹700 and starts to form a rounded top. The price subsequently consolidates to a range of between ₹660 and ₹680. This range becomes the handle. Once the price breaks down below ₹660 with high volume, the inverted cup and handle pattern is confirmed.

The height of the cup is equal to ₹700 minus ₹660, which is ₹40. Therefore, the expected target is ₹660 minus ₹40, which equals ₹620.

This example illustrates the predictive capabilities of the pattern in forward price movement.

How to Make Better Use of This Pattern

Utilisation of the inverted cup and handle pattern along with other technical indicators yields better results. Other tools that can be incorporated include:

RSI (Relative Strength Index): An overbought reading in the RSI supports the bearish pattern.

MACD (Moving Average Convergence Divergence): A bearish crossover occurring close to the handle area supports the pattern affirmation.

Moving Averages: The stock being under its 50-day or 200-day moving average enhances the bearish signal if the stock is below these ranges.

Support and Resistance Levels: Validate the pattern to check if the handle breaks a significant support level, which is a strong supporting trend line for the pattern.

Mistakes to Avoid While Trading This Pattern

Although this is a good pattern to follow, there are many mistakes traders tend to make. Their points to be noted are:

Don't draw the line too close by entering the trade without waiting for the confirmed breakdown. Trade upon confirmed close underneath the support line.

Avoid engaging with these patterns if the stocks suffer from low trading volume, as these are not very dependable.

Even the best patterns can go awry, which is why ignoring a predetermined stop-loss can be detrimental. Never take that chance.

Basing a decision on other market conditions and indicators in addition to the ones selected is always a necessity before making a decision.

Difference Between Cup and Handle and Inverted Cup and Handle

Both the cup and handle pattern and inverted cup and handle have similar structures but are opposites of one another. The first is bullish while the latter is bearish.

In a standard cup and handle, price goes up, falls downwards into an upwards shaped ‘U’, and then a downward handle follows before price increases. Inversely, an inverted version sees the price create an upside-down ‘U’ followed by a framework of a small upward handle before a decrease.

The two should not be mixed up. The major distinguishing factor is whether the breakout occurs to the upside or downside.

Who Should Implement This Pattern?

This pattern will come in handy for:

Swing Traders: To devise plans for short-term trades during market pullbacks.

Intraday Traders: To capitalise on minor upward movements within lower timeframes.

Positional Traders: To time the getaway from long positions.

Short Sellers: To identify shorts with a high probability of success.

Even for traders who do not deal in short selling, knowing about this pattern helps in avoiding the temptation of holding onto a stock that’s destined for a further decline.

In Conclusion

The inverted cup and handle pattern stands out as one of the strongest bearish indications. It allows traders to set alert for impending downwards movements for a stock that has shown signs of consistent upward movement over time. Having good early spotting of this pattern assists in planning due trades that revolve around strategically timed exits or getting into short sales.

Like any technical setup, it should not be used in isolation. It should always be complemented with other metrics, use disciplined risk management, and confirmation should be awaited before taking action.

Over time, you will become more skilled at recognising and utilising this pattern. So the next time you notice a rounded top, slight rise, and sharp fall that follows, remember—you could be observing a classic form of an inverted cup and handle.