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Treat Upward-Sloping Handle Like A Trap: It's Best To Avoid

No matter how perfect a cup may be, a flawed handle can ruin the entire structure. And perhaps the most ominous flaw could be an upward slope to the handle's development.

Think of what a cup-with-handle base is supposed to be. A stock falls, bottoms out with new-found support, and goes up. It reaches as high as the cup's left side, a few pennies or dollars more or less. As the stock swings higher, so do hopes for its future. It attracts the attention of new investors — lots of them.

Then the stock hits some profit-taking, typically within sight of new highs for the move. The last remaining impatient weak hands bail out.

But the selling isn't violent. Crucially, willing hands (usually professionals) will meet the selling on the way down. They're adding to their positions without bidding aggressively.

That's the shakeout. Weak hands give shares to the strong. That's what a properly formed handle is all about.

Many of the strongest stock advances are preceded by a shakeout. Go ahead, be cynical: A shakeout appears because everyone can't make money. Some must be scared out so they'll have to scramble to get back in.

So when you see the handle wedging higher along its lows, you know a few people are still chasing the stock higher. That's the opposite of a shakeout. And when the stock breaks out from that poor handle but doesn't drive up fast, the most eager buyers tend to be already in the stock. Who's left to drive the price sharply higher? Worse, the stalled stock will then start to worry all the overeager longs. That's how failures appear.

Hewlett-Packard (HPQ) showed what can happen to a stock that builds an upward-wedging handle. The computer giant built an oddly shaped cup base from July to early November 2003 1. A 9% drop in the week ended Aug. 22 made the cup deformed in shape. Normally, you want to see smooth, tight price action as the left and right sides form.

The stock traded tightly for a few months, decisively regaining its 10-week line after seven weeks. Hewlett-Packard hit as high as 23.70 in early November. Then it backed off, and a handle took shape.

At first glance you might like the handle: It held support at the 10-week moving average with mostly tight trading. But a simple trendline shows you a rising wedge along the lows. The January breakout was short-lived.