The Power of the Cup and Handle

This column was originally published on RealMoney on Jan. 3 at 1:05 p.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Many powerful patterns in the stock market offer potential measurement plays to both the upside and downside. Today I want to talk to you about what I feel is the most powerful of them all, because of the time it takes to form and because of the very strong upward measurements it usually has.

It is important to know, however, that there are many rules involved in this pattern -- known as the cup and handle -- that, if not followed properly, will bring you a lot of unnecessary pain.

The Nazz is in this pattern currently, and you can see the length of time it took to form. Eight long months, but oh, how important it is to know how to play it properly, because the measurement up will surprise all of you.

I want you to first recognize the shape of this pattern. It literally looks like your typical kitchen drinking cup with a handle, with the rounded bottom forming the cup and the lateral consolidation forming the handle at the end.

The first requirement is that it start with a move lower, as you can see began here in late April. The move down has no timetable, lasting days, weeks or even months. The volume on this move down will usually be about average. Of course, there can be days that are a bit heavier volumewise, but the overall trend will be roughly average. Again, it's a move lower on about-average overall volume.

Second, you begin to see a rounded bottom. It doesn't have to be perfectly rounded, but you can see from the chart how the June-through-August period starts to have a cuplike bottom, especially when connecting the lows on the way down. This is critical because this process takes us to our next step. Volume again is usually about average overall, with of course the occasional exception.

Next is the move back up, which on this chart you can see begins in late July. The volume on the upside will tend to trend to the upside as the issue moves up. It doesn't have to be more than average, but you'll often find that the volume trends are more positive overall.

Now please notice when the issue began to move lower, its high was 2378. Eight months later, it peaked right at 2378, forming a symmetrical play. Notice from there how it starts to move laterally just below and at 2378 for a while. That's step four. It gets back up to the peak price and moves laterally for period of time. It can move this way for days, weeks or months.

Step five is big. It then breaks over the double top at 2378, which you can see occurs in early November. You have your cup breakout. That's breakout No. 1. The measurement is now under way. However, once this breakout occurs, you'll see a lateral consolidation again with two tops at 2470. This is the handle that matters, above the double-top breakout over 2378. Eventually this handle will have another breakout, and that's when the measurement pattern has been well established. So it's two breakouts: the first over the double top at 2378 and the next one, in time, over the handle high at 2470.

Click here for larger image.

So how do we know how far this pattern measures? This brings us to step six.

The peak in the handle breakout was 2470 before it moved a bit lower. Notice the bottom on July at 2012. What you do is take the difference between the peak at 2470 and the low at 2012, or 458 points. Now you take that 458 points, and from the point of the first breakout peak at 2470, you add on 458 points and you get Nazz 2928. The time to make the measurement is not known. It can take days, weeks, months or even years when dealing with something as large as this issue.

You will see this pattern set up numerous times in all bull markets. It's imperative that you get used to the look of this pattern so as to take advantage of it. Please also remember that if a stock is having its earnings report, you need to be very careful, because that is the type of situation that can change the technicals in a heartbeat.