Diamond Pattern Trading
The diamond pattern is an advanced chart pattern that is used for identifying reversals in the financial markets. When correctly utilized, it is one of the most profitable patterns for trading reversals. A diamond chart pattern has similarities to a head and shoulders pattern while having a V-shaped line. However, it is a rare chart pattern which is why many technical traders and investors do not know too much about it.
Despite the rarity of its occurrence in the market, it is starting to attract the attention of traders. The profit potential it holds is starting to get noticed. The diamond chart pattern mainly features four trend lines. Two resistance lines above and two support lines below which respectively link the prevailing highs and lows in the market. The fluctuations in price widen initially before becoming narrow in this chart pattern. This article will be examining the major points of how to identify and trade the diamond pattern in financial markets.
The Diamond Chart Pattern
The diamond formation is a member of the group of classical chart patterns. Classical chart patterns include head and shoulders, pennant, rectangle, and flag patterns. These chart patterns are all commonly seen on price charts except for the diamond pattern which is seldomly seen. This is why the diamond chart pattern does not have as many trading opportunities as its fellow counterparts in the same group. However, technical traders should gain knowledge about this pattern. It holds immense profit potential if it is identified in good time.
More often than not, the diamond chart pattern gets mixed up with the head and shoulders chart pattern. While these two patterns have some similarities, there are distinguishable differences between them. The diamond pattern is usually seen after an extended trend phase and it consists of two types. There is the diamond top or bearish diamond pattern which is seen in the context of a bullish market and has bearish implications. The other type is the diamond bottom or bullish diamond pattern which is seen in the context of a bearish market and holds bullish implications. The image below depicts the details of the structure of the diamond chart pattern.
The image above shows what the diamond top formation looks like. When you observe it closely, you will see a strong uptrend just before the diamond structure. It is such that the market consolidates to a high point before retracing to a lower point followed by the market rallying to a higher high. This is then followed by prices falling beyond the previous swing low to create a new swing low point.
There is a reversal as prices now move higher once again to create the peak in the structure. It is succeeded by the price action moving lower but without replacing the preceding swing low point. Prices once again rally to a higher point before settling below the previous peak point that was achieved. Prices then drop once again but this time, they stay above the previous swing low point.
After the completion of this price action, it is possible to then plot four trendlines that have virtually equal lengths. Trendlines link the swing highs at the top of the formation and the swing lows at the base of the formation. This leads to the formation of a diamond-shaped appearance thus giving birth to the name of the pattern we are examining.
It is not always the case that all of the previously specified fluctuating price movements will be seen in the fundamental definition of the diamond structure. This does not always invalidate the structure’s designation as a diamond pattern. The most important thing is to be able to plot four trendlines that are relatively similar in size around the structure.
Types of Diamond Patterns
As mentioned earlier, there are two types of diamond patterns. The bearish diamond pattern and the bullish diamond pattern.
Bearish Diamond pattern
This is also known as the diamond top. The pattern can appear like a set of upper and lower price movements that look like the structure of the head and shoulders pattern. To be more specific, the structure of the bearish diamond pattern is such that the head and left shoulder will join to form a trendline. The head and right shoulder will also join to form another trendline. With that, the trendlines for the upper section of the bearish diamond pattern will be completed. For the lower section, the swing lows will have to be joined within the troughs to create a V shape.
The structure of the bearish diamond pattern is described in the image above. The image further displays the breakout entry signal required to trade the pattern as well as the target level for the pattern. In terms of the short entry signal, it will be activated at the break and close below the right-hand line that is on the lower part sloping upward. Another alternate entry point is to be patient for the breakout just below this line without needing the close below it. While this alternative entry point is possible, it should be highlighted that it produces false signals. More false signals than the first option of waiting for the breakout and closing condition before trading.
Bullish Diamond Pattern
This is the direct opposite of the bearish diamond pattern. This pattern is also known as the diamond bottom as it is seen in the context of a downtrend. This form of diamond pattern typically features a strong price moving lower. Then it is followed by a consolidation phase that creates the upper and lower swing points of the diamond bottom.
In this case, the structure will have a similar appearance to the inverted head and shoulders formation. The peaks and troughs will be joined within the structure following the same principle that was described earlier. After plotting the four trendlines around the structure, and then confirming that the four lines are almost equal in size, the structure can now be verified as a bullish diamond pattern as seen in the image below.
If we examine the image above closely, there is a downward price move before the formation. Also, the up and down sequence in the diamond structure is noticeable. It is depicted by the two upper trendlines pointing in a downward direction while the two lower trendlines point upward.
The point of the break and close is where the long entry signal is activated just above the upper right-hand line sloping downward. Again, the ideal option will be to remain patient for a true breakout and close instead of relying on a breakout just above this trendline. Remain patient to avoid trading with false signals. Also to avoid possible whipsawing price action that tends to characterize this area.
How to Trade Diamond Pattern? Diamond Pattern Trading Strategy
It is time to move to how to set up a trading strategy that is based on the diamond pattern. From the previous discussion above, we have learned that diamond formation can be found in the context of both an uptrend and a downtrend. Just as a reminder, a diamond top occurs when the diamond pattern is preceded by a bullish price move. Move which has a bearish significance. When it is a bearish price move that precedes the diamond pattern, then it is known as a diamond bottom which has a bullish significance.
In examining this diamond trading strategy, we intend to keep it succinct and straightforward. Straightforward by employing an approach that is based on pure price action. Bearing in mind that the diamond pattern is not the type that occurs frequently in the market. A few variables will be introduced to the strategy so that it does not become overly complicated and confusing. To set up a trading strategy, there are rules that determine how to trade a diamond top and a diamond bottom and we will be examining them now.
Rules for trading the diamond top chart pattern
1. A clear uptrend must have been identified before the diamond top is formed.
2. The diamond top formation should have a visible outline created through four trendlines. Trendlines that are linked to one another and are relatively similar in length as well.
3. A sell order should be initiated in the market once there is a break and close below the trendline sloping upward close to where the pattern is completed.
4. A stop loss should be positioned at the latest swing high that comes before the breakout point.
5. The calculation of the target level will be done by applying a measured move technique. This is the distance between the highest high and lowest low in the structure. That will be measured after which it will be projected downward from the breakout point. The importance of this projected level is that it will function as the profit exit point.
6. An extra time-stop component will be added to the trade. If after the price moves around 50 candles and it still fails to activate either the stop loss or target level, then the trade must be exited.
Rules for trading the diamond bottom chart pattern
1. There must be a visible downtrend in place before the diamond bottom is formed.
2. The diamond bottom formation should have a visible outline created through four trendlines. Trendlines that are linked to one another and are relatively similar in length as well.
3. A buy order should be initiated in the market once there is a break and close above the trendline sloping downward close to where the pattern is completed.
4. A stop loss should be positioned at the latest swing low that comes before the breakout point.
5. The calculation of the target level will be done by applying a measured move technique. The distance between the highest high and lowest low in the structure. That will be measured after which it will be projected upward from the breakout point. The importance of this projected level is that it will function as the profit exit point.
6. An extra time-stop component will be added to the trade. especially if after the price moves around 50 candles and it still fails to activate either the stop loss or target level, then the trade must be exited.
The rules are almost the same in both the diamond top and diamond bottom. There are differences in the direction of the trendlines and market orders as one features a sell order while the other features a buy order. The strategy should be easy to understand now and we will be backing it up with some practical examples to provide further clarity.
Examples of Diamond Pattern Trading
In this section, we will examine two examples of how to set up a diamond pattern trade and the examples will be based on the two types of diamond patterns. Two different forex pairs will be used to explain the examples in detail for a clear understanding.
Bearish Diamond pattern trading example
In this example, we will be looking at how to set up a bearish diamond trading pattern for a currency pair. The setup will be based on the strategy that was discussed previously and it will be reflected in a major currency pair of the euro and Us dollar (EUR/USD). The image below depicts the price chart for the EUR/USD pair based on the trading Daily timeframe.
Since the diamond trading strategy is mainly based on the analysis of pure price action, it means there is a need to closely monitor the price. Monitor for potential indications of a developing diamond chart formation. Looking closely at the EUR/USD price chart, the diamond top pattern is clearly outlined. You will observe that the diamond formation begins with the price making a swing low before moving to a higher high. Then to be succeeded by a new swing low and a swing high before finally making the last swing low that precedes the breakout.
Furthermore, you will observe that the two lines linking the swing highs and the two lines linking the swing lows are of relatively equal sizes. That is in line with the previous discussion about diamond formations. This provides the validation we need. Confirm that it is a truly symmetrical diamond top pattern that requires further examination.
Now that the structure has been labeled as a diamond formation, the next step is to ensure that there is a very visible uptrend. The uptrend that precedes this diamond top formation. From the illustration above, the price action leading to the diamond top reflects the presence of a strong and consistent uptrend in the market. This is a validation of the trending requirement based on the strategy that was previously discussed. Preparations can now be made for a possible short trade.
Bullish Diamond pattern trading example
In this example, we will be looking at how to set up a bullish diamond trading pattern for a currency pair. The setup will also be based on the strategy that was discussed previously. We will be examining the daily chart of the currency pair involving the US dollar and the Japanese Yen (USD/JPY). The image below depicts the USD/JPY chart.
Looking at the lower part of the price chart shown above, the forex diamond pattern is represented by four trendlines. Trendlines with the center of the diamond bottom formation having the longest length. Also present are the two swing high points. Points that join each of the two upper sections of the diamond bottom formation. Likewise, the two swing low points can be seen as they join each of the two lower sections of the diamond bottom formation. As a result, the overall structure of this formation appears similar to a diamond. Each of the four trendlines reflects price action within the pattern and has a relatively equal length.
After outlining the characteristics of why this is a diamond pattern, let us now examine more details. Based on the rules of our strategy as earlier discussed, a clear downtrend has to be present before a diamond bottom pattern is formed. Looking at our chart above, it is clear that this requirement has been met. The prices were moving in lower in a steady momentum before the diamond bottom was formed. The next step is to get ready to capitalize on a possible long trading opportunity.
Looking closely at the trendline that functions as the signal line, it will be observed that there was previously a false breakout to the upside. This triggered the price action to temporarily breach the right-hand trendline on the lower part. Then the prices reversed to provide a second breakout opportunity which serves as another entry point to make a purchase. Immediately after the buy order is executed, a stop loss will be placed at the latest swing low, just before this breakout.
Once again, the calculation of the price target will be done by utilizing the measured move technique. That involves measuring the distance between the peak and valley within the diamond formation. From the chart, it is clear to see that the target was easily attained and it was done before the 50-candle time-stop exit. This makes it possible to have profitably maximized the complete price move from the point of entry to the target level.
So far, we’ve learned that the diamond pattern can have either a bearish or bullish interpretation. Interpretation based on the current price movement in the market. When the diamond pattern is bearish, it is known as a diamond top and if it is bullish, then it is known as a diamond bottom.
Diamond patterns are reversal patterns. They are present across all the various categories of financial markets. Whether it is the crypto market, stock market, futures market, or forex market. The only caveat is that the diamond pattern is not regularly seen like the more familiar chart patterns. Then it is important that traders (whether beginners or professionals) understand this pattern. Also recognize it so that when it is present in the market, they can quickly spot it, and take advantage of it for profitable trades.
The diamond top pattern provides traders with a trade setup of a higher probability for profit. Higher than the diamond bottom pattern which usually happens after a fall in market prices. However, it is still recommended for traders to carry out their testing procedures. Testing to determine if this information aligns with the markets they are trading.
Overall, diamond pattern trading is quite easy to adopt. Easy once you can be patient and understand the underlying principles. It should be noted that when trading with a chart pattern, it is always prudent to have an added confirmation signal before entering a trade. This will increase the possibility of the pattern getting completed. Also raising the likelihood of the price reaching your target. An excellent tool that can be used for confirmation is the stochastic oscillator. This is a good indicator of a change in price momentum before a breakout.
Due to its lack of frequent occurrence, it means anyone with sufficient knowledge can quickly recognize it. Then capitalize on it to make some significant earnings. Also, never forget that your risk vs reward potential is one of the most crucial factors that you have to consider as a trader. Therefore, before placing a trade, you must confirm that the reward is worth the risk. So, go ahead and use the knowledge gained from this article. Expand your trading horizon while simultaneously opening up new trading opportunities for yourself.