Lesson : Finding Flaws In The Familiar Cup-With-Handle Base

Cup-with-handle bases are often the chart reader's equivalent to a horn of plenty. They are the most common among the successful types of bases that leading stocks form before breaking out.

But the cup is not a guarantee.

There are two basic ways for investors to defend themselves against the risk of a failed breakout, even in these most welcoming of bases. First, know as many common flaws as possible regarding cup-with-handle bases.

Second, remember to mind fundamental weaknesses often shown by stocks forming otherwise healthy chart patterns.

These cues were vital when Netflix (NFLX) broke out from a poor cup with handle in April 2006. The second-stage base began forming in November 2005, atop a big seven-month run.

In late January, a big-volume spike in the middle of the cup (1) shook up the desired formula of an orderly shakeout of weaker shareholders. The 19% gain in big weekly trade was a sign of strong institutional buying. That's bullish. Yet it also disrupted the symmetry of the base. Wild, swinging action is a red flag.

It was also possible to see the base as a cup that started with the late-January spike as its left side. But in this case, the base didn't have the required 30% prior uptrend before dipping into its cup. Another flaw.

A handle began forming in late March. It drifted lower, according to plan, but was punctuated by a shakeout in heavy trade on April 5. This was not a flaw, however; without the decline that week, the handle might have lacked the downward drift seen in good handles.

At that point, Netflix was just moving into high-definition (HD) disc rentals. It was committed to being a player in the streaming video-on-demand game, but the company still saw that market as "several years away."

A cup base has less luster when a stock's fundamentals are just mediocre. In Netflix's case, the company was recovering from a 44% drop in EPS in 2005. The SMR Rating was a healthy B, but its Composite Rating was a just-passing 80. The Industry Group RS was a B-.

A weak EPS Rating of 60 was not leadership grade. While the stock's Relative Price Strength Rating was a solid 91, the Relative Strength line was nowhere near a new high as the stock broke out in strong trade on April 18-19, 2006. The result: Shares climbed 12% in three days, then reversed (2). It dropped 45% in four months.