Technical analysis of chart patterns is a core technique used by options traders to identify trading opportunities. The inverse cup and handle pattern is an important formation that signals potential bullish continuation or reversal moves in a stock. This article will examine how to spot the inverse cup and handle, strategies to trade the pattern, and tips for profiting from this setup using options.
What is the Inverse Cup and Handle Pattern?
The inverse cup and handle pattern forms after a downward trend, signaling a potential bullish reversal once completed. It is the inverse version of the standard “cup and handle”. The pattern contains three stages:
- Cup Formation – The start of the pattern is the “cup” which charts a rounded U shape over several months showing the prior downtrend. Volume declines during the selloff.
- Handle Formation – The handle forms the bottom of the cup as a short consolidation lasting 1-4 weeks with declining volume. The handle traces a mild upward drift to complete the cup shape.
- Breakout – The inverse cup and handle triggers after a breakout above the upper resistance level that formed the rounded top of the cup structure. Higher than average volume confirms the breakout.
Once the stock breaks out above the upper resistance of the cup, the inverse pattern signals a potential change to an upward trend.
How to Trade the Inverse Cup and Handle Pattern
Here are approaches for trading the inverse cup and handle with options:
- Buy a call option after the breakout above cup resistance anticipating continued upside. Choose a strike above the breakout level.
- Buy a call spread after the breakout to define maximum risk. Sell a higher strike call to fund purchasing a lower strike call.
- On breakout, sell put options below support expecting further upside. Choose expirations allowing time for the new uptrend to develop.
- After cup resistance is exceeded, sell a put spread with a higher strike short put to finance buying a lower strike long put. Defines risk.
- Once breakout occurs, sell out-of-the-money bear put spreads expecting a bullish trend. Sell higher strike puts and buy lower strike puts.
Strategies for Trading the Inverse Cup and Handle
Here are some strategic ideas for using the inverse cup and handle pattern:
Confirm the Validity – Ensure above average volume is present on the breakout for confirmation. Review the structure to validate a true inverse cup and handle formation.
Time the Entry – Plan option entries just after the stock breaks above the upper resistance level that formed the top of the cup shape.
Manage the Trade – Set a stop loss below the lower support of the handle. If this level fails, exit the options trade.
Consider Trend Lines – Draw uptrend lines connecting the low points in the cup. Use these to identify key support levels for stop losses.
Account for Earnings Reports – Review upcoming earnings dates which may alter the price action. Avoid strikes too close to the announcement.
Analyze Volume Changes – Study volume spikes on the breakout for conviction. Volume should rise significantly above the cup levels.
How to Make Profits Using the Inverse Cup and Handle
There are several ways to profit from the inverse cup and handle pattern in options trading:
- Buy Calls or Call Spreads on Breakout – Capture a sharp move upward after buy signals trigger when upside resistance is exceeded.
- Sell Puts or Put Spreads on Breakout – Earn income from puts expiring worthless as the stock trends higher in the new uptrend.
- Leg Into Spreads to Define Risk – Manage winning upside trades by legging into call or put credit spreads to define maximum loss.
- Close Trades Early to Capture Profits – Keep size small, take profits quickly. Close positions before expiration once a sizable gain occurs.
- Hedge Long Trades With VIX Calls – Consider buying VIX call options to profit from volatility spikes and hedge long trades.
- Use Pattern for Swing Trades – Employ the inverse cup and handle for shorter term swing trades holding options for several days to weeks.
Tips and Tricks for Trading the Inverse Cup and Handle
These tips can help improve success with the inverse cup and handle pattern:
- Utilize a chart timeframe appropriate for the cup size – daily charts for long-term cups or intraday charts for smaller cups
- Evaluate prior uptrend strength before the selloff to gauge potential rebound momentum
- Combine with other indicators like rising volume, bullish crossover signals to confirm entries
- Be flexible on pattern days requirements – some valid setups form over shorter time periods
- Monitor option time decay – avoid purchasing options too early before confirmation of breakout
- Consider trading the pattern in broader indices for diversification when high quality setups appear
- Manage position size appropriately without over-allocating capital to a single setup
The inverse cup and handle marks a potential turning point after a selloff, signaling a shift to an upward trend upon confirmation. Options traders can capitalize on this pattern by using solid risk management practices. Carefully verify the pattern structure, utilize calls or credit put spreads after upside breakouts, and enforce disciplined trade management. By mastering trading tactics for this reliable chart formation, options traders can profit from bullish reversals. The inverse cup and handle provides attractive opportunities to capture upside.