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| 3RD WATCH |
From THE MASTER SWING TRADER
© 2006 McGraw-Hill and Brooke Publishers. All Rights Reserved. |
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William J. O'Neil first defined the Cup and Handle (C&H) breakout in his book How to Make Money in Stocks. Since that time, Investors Business Daily and other popular journals have extended the folklore of this classic pattern. But to this day, few swing traders recognize this formation's versatility or its appearance through all time frames and markets.
The generic pattern looks like a rounded cup with a small handle and represents a breakout through a triple top. Price rallies into a first high, reverses and then pulls back to form the left side of the cup. The issue eventually finds support and builds a sideways base. A new rally erupts and rises toward the old high. This forms the cup's right side. Sellers appear at the double top and the market pulls back a second time. The next decline draws the smaller handle as price again stabilizes, but this time at a higher level than the last retracement. It then rises into a 3rd rally and breaks out sharply to new highs. |
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| Classic Cup and Handle Breakout |
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| Idec Pharmaceuticals draws a perfect C&H pattern through both price and time. The cup takes approximately 3 months to form, while the handle does its job in just 1 month. The handle drops into a classic 50% retracement before ejecting strongly through overhead resistance into a dynamic 100% rally. |
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Look at the market mechanics beneath this pattern. After the first high, price pulls back sharply before it bounces. This forces oscillators to roll over and encourages longs to exit positions. Swing traders then enter new short sales when price approaches the double top test. This contributes to fresh selling pressure and forces price to pull back again. It eventually reaches support while indicators recover from oversold levels. Longs then sense a new opportunity and build volume back toward the old highs. This forms a handle base that discourages further selling and builds accumulation. Price reaches the high for the third time and breaks out.
Volume must support price action for the new rally to succeed. The original O'Neil approach demands that breakout volume rise at least 50% above the 50-day volume moving average before the new high. It searches for candidates that show more participation on up days leading into the breakout than down days. The classic definition also filters volume action within the cup itself. The rising days on the cup's right side should print higher volume than both the falling days and the 50-day VMA.
These strict requirements lead swing traders to misunderstand this pattern's power. Many predictive C&H formations never meet these standard definitions. Handles can retrace deeply or actually build a base at new highs above the cup. Volume can break all the rules as the pattern forms but still show excellent accumulation by the time the breakout erupts. And a deep handle may even push toward the low of the cup's bottom before the final rally begins.
3rd Watch seeks the classic pattern but cuts the dimensions in half. It locates breakouts that occur within 6-month highs rather than 52-week highs. The handle language in the scan captures many variations of this complex formation. It only requires that the market print no new high within 4 weeks of the signal. This allows a short base and pullback before the stock erupts through the barrier. 3rd Watch also looks for volume to spike at least 150% of average on the breakout bar. |
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| Congested Handle |
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| Immunex breaks through 4-month resistance and the 52-week high as the FDA approves a key arthritis drug. Note the November congestion right under the first high and the strong breakout. |
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Use 3rd Watch strategy to trade all triple top breakouts. While the scan outputs a specific type of C&H, the markets draw this pattern in many unique ways. Both ascending triangles and rectangle formations rely on the same price mechanics. Parallel price channel resistance often breaks on the 3rd high as momentum triggers bar expansion. Sometimes relative highs will print at an equal distance to each other, rather than in a proportional cup and handle. This powerful setup offers swing traders valuable insight and profitable tactics for all of these breakout incarnations.
The handle location provides important accumulation feedback. Volume tends to lead or lag price, especially at new highs and lows. When the handle forms below the cup, it suggests that accumulation needs to build further before a breakout can proceed. Alternatively, congestion right above two old highs denotes a very strong market that should trend sharply once it completes the new platform. Also keep an eye out for a double handle formation. This odd pattern forms a base on both sides of the two old highs. When this Cup and Two Handles (C&2H) starts to print, measure the last trend just below the first handle. Add that length to the bottom of the second handle to estimate a price target for the next rally. |
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| Focus on Day Trading |
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| Sharp traders can locate 3rd Watch formations on intraday charts, as well as daily and weekly ones. This important variation of the classic Cup and Handle provides a welcome addition to the day trader's toolbox. |
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3rd Watch offers excellent intraday trades. The setup carries few of the restrictions that limit most other Bells in the short-term environment. This dependable pattern appears frequently on short-term charts and encourages many quick profits. In addition to simple highs, look for first hour range to break on the third try. Even scalpers can apply effective Watch strategy. Locate intermediate highs on the 1-minute chart and trade quick thrusts or tick breakouts above that level.
Major intraday setups tend to peak in the last hour. A strong trend often reaches a first climax early in the day, and spends several hours testing its new range. Positive bias then carries price back towards the intraday high late in the day if the market stays strong. This encourages new speculators who hope for another trend leg, or who want to buy in anticipation of a continuation move the next morning. Sometimes markets will close just as price reaches the peak, but doesn't eject. Odds then favor a strong breakout gap when trading resumes. |
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