In our first article, we looked at how to visually recognize the valuable “cup and wide-range candle” momentum breakout pattern. In this article we’ll continue on by looking at how to manage risk, how to scale in to add to winning trades, and how to confirm entries with multiple technical entry signals.
This is among the strongest breakout patterns available to active day and swing traders.
Cup and Candle Breakouts: Risk Management
Once a pattern is recognized, the astute active trader needs to evaluate risk vs. reward and define a clear, specific trading plan for the upcoming trade. Entries for stock and ETF swing trades are set at fifty cents ($.50) above cup highs, when the momentum candle is spotted, using a $1.5 initial stop value.
In Figure 1 Walgreen Co. (WAG) the large cup is the first thing to look for, in this case going from $62 down to $55, then recovering with a wide-range candle on the right side of the cup pattern. An initial entry trigger was set at fifty cents above the high, at ($62.0 + $.50) = $62.50. The initial stop is set at $1.5 below the entry; in this case that yields ($62.5 – $1.5) = $61.0 for the initial trade.
After getting into the initial momentum breakout candle entry, a trailing stop value of $1.50 is used, to lock in profits on the trade. Managing risk is absolutely essential when it comes to successful trading, as any professional trader will attest to. When trading this pattern it’s helpful to use relatively tight, conservative $1.50 initial swing trading stops, in case a trade goes against the trader. The benefit of this pattern is that the wide-range candle that’s above prior resistance is an ideal place to attract new buyers, which is why these often continue in-trend for the trader, once in a position.
Scaling In To Cup and Candle Breakout Continuation Trades
Adding to winning trades once they’ve been initiated is also one significant key to potential trading success. Using the cup-and-candle breakout method to identify where to scale in to winning trades can be particularly successful on strong-trending charts.
For example, the one-year chart illustrated in Figure 2 MGM Resorts International (MGM) shows how effective this technique can potentially become, on successive cup-and-candle breakout continuation trades (disclosure: the author is currently long MGM and is his single largest real-money position trade as of February 2014).
Scaling in by adding a new allotment of shares to an existing position during uptrend continuations as shown in Figure 2 can help leverage an initial winning trade into more substantial profits, when traded correctly. A good rule of thumb is to wait until an existing position has moved at least 2 points (and no more than 6 points) before adding to an open winning trade. This is to minimize stop-outs due to pullbacks and consolidations, while adding to winning trades that continue.
After scaling in, the stop loss is then moved up to breakeven. Adding in equal increments, such as 100 shares at a time, can be an effective method to scale in to winning trades.
Confirming Entries With Cup and Candle Breakouts
The single most important technical confirmation is increased volume at the right side of the cup, when the wide-range candle is seen. A minimum of 30% larger volume size is best, to confirm that the wide-range candle has in fact been generated by institutional and/or other large “significant” buyers, which can drive price high, in the traders’ favor.
Since this is a momentum signal, we do not use oscillation indicators such as moving average crossovers nor stochastics nor RSI nor others, since it’s a pure price-action momentum driven play. Volume is the best indicator to use when confirming whether or not a trade is worth taking, because “professional traders vote with volume”.
Final Thoughts On Cup and Candle Breakouts
Since this visual visual pattern of wide-range candles gets the attention of other momentum active traders, and is easy to spot visually on a chart, it should be a core tool in every active traders’ toolkit. Since it relies upon pattern recognition skills, it’s helpful to practice spotting these patterns and doing test trades in a demo/papertrading account to work on fine-tuning one’s trading skills, to sharpen entries and to potentially generate bigger winning trades, more often.
Price-action based trading patterns such as these are easy to spot, yet difficult to master, since traders often mistakenly use this type of approach with risky penny stocks or too-expensive (over-$100/share) stocks. Sometimes traders are not patient enough to wait until a strong enough candle appears at the right side of the cup, prior to entering. Developing the ability to quickly recognize and trade this pattern carefully, strategically and successfully is a hallmark of a skilled professional trader.
Recommended reading: For more on candlestick charts, learn from the world’s foremost authority and author’s colleague Steve Nison, in his book “Strategies for Profiting With Japanese Candlestick Charts (2011, Wiley Trading). For more on scaling and position sizing, see Dr. Van K. Tharp’s “Van Tharp's Definitive Guide To Position Sizing” (The Van Tharp Institute, 2013). For more on using this pattern, see the author’s complimentary Saturday “Trading Week Ahead’ webinar events.
Ken Calhoun is a trading professional who has traded millions of dollars of equities since the 1990s, and is the producer of multiple award-winning trading courses and video-based training systems for active traders. He is a UCLA alumnus and is the founder of TradeMastery.com and DaytradingUniversity.com, popular online educational sites that reach tens of thousands of active traders worldwide.