Friday, March 31, 2017

Unmasking the Voodoo - Cup with Handle

Anyone who ever discovered a relationship in the stock market and decided to go public with it probably created an indicator - which they named after themselves - or described a pattern or cycle and gave it a really catchy name. I want to focus on the latter in this post.

First of all, let's start with marketing. Ralph's OK Chart Pattern is not going to sell a lot of technical analysis books. It won't get a lot of page reads online. And it won't be worth anyone's while to publish it without the advertising potential. Forget about seeing it coded into TradeStation.

It does not matter if it works or not. Or even if it really works. I mean reeeaallllly works all the time and makes oodles of coin to impress the ladies (or gents, I don't judge).  The only way someone will care about Ralph's OK Chart Pattern is if they 1) find out about it at Ralph's OK workshop at Traders Expo or 2) find out about via a catchy headline such as "Ralph has unlocked the secret of the market with a chart pattern that works every time with no draw downs!"

OK, that's extreme. But what if Ralph's pattern had a better name? One that is easy to remember. And one that cuts through the clutter of every other Ralph out there with his own pattern?

To me, cup-with-handle is just a perfect name. First, you can visualize it even without a chart. Second, it actually describes what you see. And third, there is actual technical analysis behind it.

Of course, a lot of people seem to forget that last part.

There really is a some theory behind the picture but why let that get in the way of a good forecast?

Back in the day when William O'Neil concocted it, the cup-with-handle was a bullish continuation pattern that formed over a period of three-six months.

Let's dissect that definition. First, it is a bullish pattern in an uptrend. Nowhere does it say it works in a down trend although we technicians like to think every pattern works in all markets and in all time frames. For sure, some do but not all. In the stock market, and that is where the pattern was developed, up trend and down trends have very different personalities.

Next, nowhere does it say that the cup-with-handle is a reversal pattern. It says it is a consolidation in an uptrend. It did not say it was bullish no matter what.

Now, that does not mean there cannot be a similarly shaped pattern at the end of a bear trend that reverses the market to the upside. It's just not a cup-with-handle.

Now, I just pooh-poohed the notion that the pattern only works in a three to six month period. If you really understand what is going on then you will see that it does translate to other time frames - barely. The built in technicals of support, volume and consolidation do apply across time frames. But again, can we call it a true cup-with-handle?  Going by the definition handed down by the creator at the IBD alter it is not a true cup-with-handle.

OK, that's picky. But the part about it being a bullish consolidation pattern in an uptrend is untouchable.

Now it is time to get into the pattern so you know what you are talking about - in a way people can and want to understand - the next time you get interviewed on the Consumer News and Business Channel. Yeah, that's CNBC.
Nerd Note: Originally established on April 17, 1989 by a joint venture between NBC and Cablevision as the Consumer News and Business Channel, the network later acquired its main competitor, the Financial News Network, in 1991. Cablevision later sold its stake to NBC (Wikipedia).
Sorry, I am still kicking myself for turning down a gig with them back then.

Anyway, the cup-with-handle describes what happens after a rally. The stock eases back down on diminishing volume. Endures a period of low volume, low volatility trading. Starts to recover as volume picks up before finally erasing the whole decline.

If you want a chart, visit with my little friend Google. or be wild, try Lycos, Hotbot, Ask or Webcrawler. OK, you can try Yahoo, too.

Now, at resistance from the old high the stock pauses again.

Think about this for a moment. In any pattern, a pause at resistance gives bulls and bears a chance to think about life without having to trade. In most patterns, price action touches resistance or the upper border of the pattern a few times. Why? Supply overwhelmed demand at that relatively high price.

Sometimes a stock will slice right on through resistance immediately after bouncing off support. This sort of breakout - usually due to momentum - is not reliable. I'd rather see everyone calm down at resistance so that a breakout attempt results when there is a sea change of attitude. What was once relatively expensive suddenly becomes relatively cheap. That's a true breakout.

It could be a product launch, the CEO finally clearing that intestinal blockage or some other mood bending occurrence from the Fed, oil prices or Gollum. It does not matter why on the charts.

The charts tell us that something changed. Knowing exactly what does not make us any money. Taking action does (or should).

Picking up where we left off, we have a stock that rallied, pulled back in a defined manner to really allow all excesses to be wring out and then a pause back at the old high. Remember, we like pauses at resistance as good setups.

Then the stock eases back a bit. Aye, a bit. It's subjective but if it looks small relative to the overall pattern then that is ease-y enough for me.

What is that important? Because it tells us that bulls were mostly holding on to their shares. A lack of buying rather than heavy selling caused the small price decline. How do we know? Because volume eased back with it.

You might recognize that as a flag pattern elsewhere.

The fun comes when the small pullback is resolved to the upside. Another sea change towards the bullish side and away we go!

And if the pause keeps going and either a lot of time passes (like months) or price sags too much then there is no breakout and no buy signal.  Just as with any other technical chart pattern.

Sure, you can describe the pattern with what unfolds on the chart but the voodoo-less way would be to talk about why the ups and downs appear:
  1. A stock rallies
  2. It reaches a point where the price entices supply to appear and demand to wane.
  3. That creates a pullback as bulls lock in profits.
  4. Then the market loses interest and the stock languishes for a while.
  5. But since the stock was bullish only a few weeks ago some people decide to buy it on sale.
  6. They tell two friends and they tell two friends and before you know it the stock slowly recovered.
  7. That was not lost on the bears and the other nattering nabobs who see another chance to sell at the old highs.
  8. Once again, the stock eases back but not too much because not too much supply came out.
  9. Something sparks the next breakout and suddenly what was expensive is now considered cheap.
  10. Bulls pile in and volume increases.
  11. The stock rallies again. 
Note how some of that is silly for a stock in a down trend. The premise that the stock is generally a long-term winner is important in the intermediate-term gyrations.

When you know why a pattern forms you will understand what the market is telling you when it happens.

And one more thing - the cup portion has to look like a cup. It cannot be a sharp reversal with a champagne class. That leaves no time for the market to forget about it. And it cannot be an overly long period of malaise with a fancy soup dish. A quiet stock is not a dead stock.

It has to be a U-shaped cup with low volume in the middle.  It has to let the volume curve play out, too.

Let me live 'neath your spell
Do do that voodoo that you do so well
'Cause you do something to me
That nobody else could do
- Frank Sinatra

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