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Downey Financial's Cup and Handle

07/17/01 10:29:27 AM
by David Penn

Another small cap financial company looks to ride the bull.

Security:   DSL
Position:   N/A

It's days like these that make me feel like the patron saint of ugly chart patterns. Nevertheless, Downey Financial (DSL) had a great day on Monday: a gap up two points, virtually closing at its high for the day, and possibly starting what could be a 20% move. But this move looks contingent in part upon an unattractive cup and handle with a broken base and a quick, shallow handle. If you make your decisions based on the aesthetic beauty of chart patterns, you may prefer to pass on charts like DSL. However, the big volume gap up on Monday is more than enough to merit more attention.

What detracts from this otherwise strong breakout from a cup and handle formation is the April rally, ironically enough, which rippled through DSL in the form of a seven-point rally from the March lows. The beginning of an upward trend in on-balance volume in late March that accompanied this move (combined with the price advance itself) was a bullish development. Less than eight weeks later, during the June advance, DSL tested and exceeded the highs reached in April. This rounding action forms the bottom of the "cup" in the cup and handle formation. The rounded nature of the price correction and rally in the cup and handle is much more preferable in many cases to the V-shaped or parabolic correction and rally patterns, as the rounded nature of the cup can afford more opportunities for support should prices retreat.

Figure 1: A bullish gap up on above-average volume may be the start of a successful, upside cup and handle breakout.
Graphic provided by: MetaStock.
This is especially so in the case of the cup and handle formation, which adds a brief correction and rally (the "handle") to the overall rounded bottom of the pattern. The correction that begins the handle often "shakes loose" weak holders of the stock, who often scramble back aboard when the stock rallies, completing the handle, and advances. These late-comers and second-guessers can help put enough upward momentum on a stock to provide good exit points for savvier traders who moved in early.

In the case of DSL, the handle on the formation is perhaps on the smallish side, correcting only 6% off the top of the formation, when authors such as O'Neil and Bulkowski recommend 10-15%. The duration of the handle conforms much better, lasting about 14-15 trading days (a minimum handle duration might be 1-2 weeks or 5-10 trading days). Cup and handle formations also come with large volumes at the beginning and end of the formation (often a selling volume at the beginning and a buying volume at the breakout), and this is no less the case with DSL, as the chart shows. Either a full or partial formation height can be added to the value at the breakout point to arrive at a reasonable upside price objective range; here, DSL's formation height of 11.5 suggests an upside price range between 55.8 and 61.5. Should DSL reach 61.5, it would have the opportunity to test its all-time high, reached in December 2000.

On a related note, there has been some conversation about when a breakout has broken out too far, so to speak. One person wrote in noting top trader David Ryan's dictum that a breakout that has already registered a 20% advance is much more risky than one that is only 5% or 10% above its breakout point. With that in mind, DSL looks to still have room for riders. At about 51.5, DSL is only 4% above its breakout point of 49.5. Using Ryan's thought as a guide, this breakout could still gain 16% before becoming dangerously overextended beyond its breakout point. This idea of overextension may be especially relevant given the fact that DSL is up on a gap.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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