In our first article on continuation patterns, we covered flags, pennants and triangles. Today, we round out our look at the topic with an analysis of two more formations: rectangle and cup-and-handle patterns.
The rectangle formation is similar in shape to a flag, with all the price action contained between two parallel lines. The difference is that while a flag pattern generally forms on an angle, the rectangle is, as its name suggests, formed of two horizontal lines.
Another key difference between the two is the duration of the pattern. Flags generally form over the course of three weeks or less. Rectangles can take up to three months to play out. It’s for this reason that short-term rectangles of three or four weeks’ duration are also treated as flags.
Have a look at the rectangle on the following chart of Comcast (NASDAQ: CMCSA). I’ve also included a flag pattern for the purpose of illustration.
As seen on the chart, the defining characteristics of a rectangle pattern are at least two touches at resistance (above) and two below at support. Ideally, they’ll move in a zigzag between the two, but that’s not necessary for the pattern to be valid. The tight range that’s formed by the upper and lower bands of the rectangle have led traders to refer to the pattern as a “congestion” or “consolidation” period, or a “trading range.”
A few more key points for the identification of a rectangle:
- A prior trend leading into the pattern should exist.
- Volume is less relevant for the formation; any manner of pattern could be exhibited.
- Breakouts could occur in either
This last point is key, particularly for long consolidations. Traders should therefore wait for the breakout (seen above in green) or for a pullback before setting their positions.
Our final continuation pattern is known as the cup-and-handle formation, a term coined by William J. O’Neil, founder of the Investor’s Business Daily newspaper.
The pattern is comprised of two elements, a rounded bottom that forms the cup and an additional, brief trading range that forms the “handle.”
The following chart of Costco (NASDAQ: COST) illustrates the formation well:
A few key points:
- Cup-and-handle patterns generally take up to six months to form, though the above example spans a full nine.
- As always, a previous trend should exist, and the cup should have a definitive rounded shape. Anything too V-shaped would not qualify and could be mistakenly traded as a continuation pattern when it was not.
- In a perfect world, we would see equal highs on both sides of the formation – as we do in the above example – but it’s not necessary. Nor does the handle have to possess a specific shape. There has to be a pullback of some variety, but it can take the shape of a flag or a pennant or even a rectangular-shaped trading range somewhat below the cup’s peak.
- Trades are generally initiated after a break above the right side high of the cup. Or, if the handle’s peak is higher, above that point.