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What A Cup-With-Handle Base Says About Investor Sentiment

Stick with CAN SLIM investing long enough, and the cup-with-handle base becomes like an old friend.

Yeah, yeah — flat bases shape up faster, and ascending and high tight flag bases might be more exciting. But a cup-with-handle has been a calculable, low-risk precursor to countless winning runs reaching all the way back at least into the 19th century.

So, why does selling by one group of institutional investors and buying by another create this pattern, and what does it tell the average investor about what's happening behind the scenes

First a quick review.

Cup-with-handle bases can be as short as seven weeks and as long as many months. They typically correct between 12% and 35%. The must be at least five days long, and is usually more than one or two weeks in length. Its midpoint should be in the upper half of the entire base. The handle should ease downward in quiet trade. The is generally plotted by adding a dime to the left-side high of the handle.

A stock's fundamental and technical traits can be distinguished from each other. But technicals — essentially a stock's chart action — are clearly driven by psychology. In fact, the cup portion of a outlines some basics of market psychology.

The left side of a cup shows fear: Investors sell off, rush out. At the bottom, supply and demand begin to find an equilibrium. Then greed takes hold and the stock begins shaping the base's right side.

But the real tell of any cup base is a U-shape, rather than a sharper V-shape, at the bottom of the pattern. While a V-shape implies a rebounding stock, a more gradual U-shape — particularly in a base taking three to six months to form — "scares out and wears out" weak stockholders and takes "other speculators' attention away from the stock," wrote IBD founder and Chairman William O'Neil in "How To Make Money In Stocks.

This is fundamental because it represents a change in psychology among institutional shareholders. The flighty and more short-term profit-oriented players get shaken out. What's left, O'Neil says, is a "more solid foundation of strong owners who are much less apt to sell" and take profits during the stock's next advance.

Consider the cup with handle that CME Group (CME) formed in early 2003. The two-week handle provided one last , with a heavy-volume dip on April 7. Trade then went nearly silent until the stock's April 17 on a 140% increase in vs. its 50-day average.

Not all cups form handles. Those that do are less prone to failure. Remember, volume should generally decline as a handle drifts lower. This last shakeout tells you most of the weaker investors have moved on. But a handle that wedges upward doesn't permit this final shakeout necessary before the breakout.