What Is a Diamond Chart Pattern, and How Can You Trade It?
The diamond chart pattern is a technical analysis tool used by traders in different financial markets for breakout trading. It can provide valuable insights into potential price movements and trend reversals. However, it can be challenging to find it in a price chart. In this FXOpen article, we will tell you how to spot the diamond formation and build your own trading strategy.
Overview of the Diamond Pattern
The diamond is a reversal pattern, meaning it can signal a potential trend change in the market. It typically occurs after an extended trend and indicates a period of consolidation before a potential breakout in the opposite direction.
The diamond can be bearish and bullish; therefore, it is also known as the diamond top pattern and diamond bottom pattern for trading. A bearish formation typically occurs during an uptrend and signals a potential reversal to the downside, while a bullish diamond pattern in trading forms during a downtrend and signals a potential reversal to the upside.
The pattern is characterised by a series of higher highs and lower lows, which then turn into lower highs and higher lows, regardless of the trend direction. This formation indicates that buyers and sellers are in a state of equilibrium, with neither of them able to gain control of the price. The breakout from the diamond formation is typically expected to occur in the opposite direction to the prevailing trend; that is, down after an uptrend and up after a downtrend.
The Diamond Pattern: Trading Rules
Like most chart patterns, this formation has particular rules traders can use to build their own trading strategies. These rules can be applied to the diamond pattern in forex, stock, and commodity markets.
Entry
The diamond is typically followed by a breakout, which can occur in either direction, indicating a potential trend reversal. If the breakout occurs above the upper trendline after a downtrend, it signals a bullish reversal. On the other hand, in the bearish diamond pattern, the breakout occurs below the lower trendline, which signals a bearish reversal.
It should be accompanied by an increase in trading volume, which adds further confirmation to its validity. Low trading volumes usually signal a false breakout (fakeout), whereby the price returns to its previous trend. Fakeouts can be caused by market volatility, news events, or other factors that disrupt the breakouts validity.
Traders may also use multiple timeframe analysis for confirmation. For example, if a diamond is forming on the hourly chart, traders may look at higher timeframes, such as the 4-hour chart, to identify the overall market trend. If the breakout aligns with the trend on multiple timeframes, it may provide a stronger trading signal.
Target
Once the breakout occurs, traders can use the diamond to project a potential price target. To do this, they can measure the highest part of the formation (the distance between the highest high and the lowest low) and add that distance to the breakout point in the bullish formation and subtract this distance in the bearish formation.
Stop Loss
In diamond pattern trading, a stop-loss is key. Traders typically place stop-loss orders just beyond the level opposite to the breakout level or beyond the apex, which is the highest point in a diamond top pattern or the lowest point in a diamond bottom pattern.
Special Consideration
Although the diamond is primarily considered a reversal formation, it can also indicate the continuation of an existing trend. Traders can see it appearing within the context of a strong trend and interpret it as a pause before it resumes.
In the case of a diamond continuation pattern, traders will go short on the breakout of the lower trendline of the diamond formation in a downtrend and go long on the breakout of the upper trendline in an uptrend. Still, the profit target will be calculated similarly to the reversal formation.
Tools and Resources for Confirming the Diamond
To confirm the diamond formation and enhance its reliability, traders often rely on a combination of technical indicators and fundamental analysis. These tools provide additional layers of validation and help filter out false signals.
- Volume Analysis: Its a key indicator in confirming a breakout from the diamond trading pattern. An increase in volume accompanying the breakout suggests strong market interest and reinforces the breakout's validity. Conversely, low volume may indicate a false breakout.
- Momentum Indicators: Momentum indicators can help gauge whether the market is overbought or oversold and spot divergences. In the context of diamond patterns, divergencewhere the indicator moves opposite to the pricecan signal a potential reversal and confirm the patterns signals.
- Moving Averages: Utilising moving averages can provide context to the pattern's formation. When the price crosses above or below these averages in conjunction with the diamond reversal pattern, it offers stronger confirmation of the breakout direction.
- Fundamental News Events: Major economic announcements or geopolitical events can trigger significant price movements that align with a breakout from a diamond. Tracking these events helps us understand the broader context.
How Can You Trade with the Diamond?
This formation can be used in various trading strategies. Here are some common approaches that traders can utilise.
Breakout Trading
One of the most straightforward strategies is to trade breakouts. Traders can wait for the price to break above the upper trendline in a diamond bottom trading pattern or below the lower trendline in a diamond top trading pattern and then enter the market in the breakout direction. Traders usually place a stop-loss order below the lower line in a bullish formation or above the upper line in a bearish formation or consider the risk-reward ratio. A trader can consider a trailing stop-loss option. The profit target is based on the distance between the highest high and the lowest low of the pattern. In a solid trend, a take-profit target can be trailed the same as the stop-loss point.
In the chart above, the price formed a bullish diamond after a prolonged downtrend. The price broke above the upper line (1). However, it couldnt stay there and later returned to the pattern. The volumes on the next bullish breakout increased significantly, so a trader could have expected bulls to succeed this time. If a trader had placed a stop-loss level below the lower line, the price return wouldnt have affected the trade (2). The price broke above the upper line and continued rising. A trader could have measured the distance between the highest and the lowest points and added this to the breakout point (3). The bullish trend was strong, so a trader could have trailed that take-profit target.
Retracement and Reversal Trading
Another strategy is to look for price retracements after the breakout. Traders can wait for the price to retest the broken trendline after the breakout and then enter a trade in the breakout direction. A profit target will also be calculated based on the distance between the highest and the lowest points. The distance should be added to the breakout point in a bullish formation or subtracted from the breakout point in a bearish formation. A stop-loss order will be placed below the retracement level in the bullish formation and above the retracement level in the bearish formation. In this approach, traders usually use a limit order. Trailing stop-loss and take-profit orders can also be applied to this approach.
In the chart above, the price formed a diamond bottom pattern. It broke above the formation's upper line but retested the line later (1). A trader could have placed a buy limit order at the upper line. A stop-loss could have been placed below the lower line (2), while a take-profit target could have equalled the distance between the formations highest and lowest points (3).
This strategy can be effective in catching potential trend reversals with better entry points and an improved risk-reward ratio. However, there is a risk of a missing trade as the price may keep moving in a breakout direction without a retracement.
Diamond and Head and Shoulders Patterns
The diamond formation is commonly compared to the head and shoulders setup. However, they have different trading rules; therefore, its vital to learn how to distinguish between them.
The head and shoulders formation consists of three peaks, with the middle peak (the head) being higher than the other two peaks (the shoulders), and is formed at the end of an uptrend. The inverse head and shoulders pattern consists of three troughs, with the middle one being lower (head) than the other two troughs, and it appears at the end of a downtrend. On the other hand, the diamond is characterised by a series of higher highs and lower lows, which turn into lower highs and higher lows.
Significance of the Diamond Trading Pattern
The diamond holds significant value in technical analysis due to its unique shape and ability to reflect future price reversals.
It represents a period of indecision in the market where neither buyers nor sellers dominate. This indecision is marked by a series of higher highs and lower lows that eventually narrow into a symmetrical structure resembling a diamond.
The reliability of the formation stems from its ability to identify shifts in market sentiment. Although it is not the most common pattern, its infrequency adds to its reliability; when it does appear, it often precedes significant market moves. However, traders should be aware that the patterns success rate is not absolute. Its effectiveness can vary depending on market conditions, volume, and external factors.
Limitations of the Diamond Formation
While the diamond can be a valuable tool, it is not without limitations.
- Low frequency. It is a reliable but rare pattern. It can be spotted on various timeframes of different assets for instance; you can find the diamond pattern in the stock, forex, and commodity markets. However, its not very common. This limitation negatively affects the ability of traders to practise frequently to improve their skills. To empower your trading, use TickTrader, a free trading platform by FXOpen with numerous technical analysis tools and assets.
- False breakouts. As with any chart formation, false breakouts can occur. Sometimes, the price may break the trendline only to reverse back within the formation. Traders should be cautious and wait for confirmation with increased trading volume and follow-up price action before entering a trade.
- Subjectivity. Like other chart patterns, it is subject to subjective judgement. Traders may interpret it differently, leading to variations in the placement of trendlines and potential breakout points. This subjectivity can sometimes lead to false signals or confusion, and traders should be mindful of this and use other technical indicators or tools for confirmation.
- Lack of precision in price targets. While the diamond provides a projected price target based on the vertical distance between the highest and the lowest points, it is not always precise. The price may not reach the projected target, and the actual price movement may deviate from the projected target due to various factors such as market volatility, liquidity, and news events. Therefore, traders should use the projected price target as a rough guideline and consider other factors in their trade management.
- Market conditions. Its effectiveness can vary depending on the market conditions. In ranging or choppy markets, the formation may not be as reliable as in trending markets. Traders should consider the overall market context and use the diamond in conjunction with other technical tools or indicators for better accuracy.
Final Thoughts
The diamond is a popular technical analysis tool used in trading to identify potential trend reversals. You can spot the diamond pattern on crypto*, stock, currency, and commodity charts. However, like any other trading tool, this formation has pitfalls, and traders should be aware of them before entering the live market. Proper risk management, multiple timeframe analysis, and consideration of other market factors are crucial. Once you feel confident enough to trade with the diamond formation, open an FXOpen account and enjoy tight spreads, low commissions, and rapid trade execution.
FAQ
How to Identify a Diamond Pattern?
A diamond is identified by a combination of higher highs and lower lows that gradually narrow into a diamond-like shape on the chart. It usually forms after an extended trend, signalling a potential reversal as the market consolidates.
Is a Diamond Pattern Bullish?
A diamond formation can be both bullish and bearish. A bullish diamond pattern forms during a downtrend, indicating a potential reversal to the upside. Conversely, a bearish diamond pattern appears in an uptrend, suggesting a downward reversal.
How to Trade a Diamond Pattern?
Trading a diamond pattern involves waiting for a breakout from the formation. Traders usually enter trades in the breakout direction, with stop-loss orders placed beyond the pattern's apex or the breakout level to manage risk and a take-profit target equal to the distance between the highest and the lowest points of the diamond formation.
What Is the Diamond Pattern Strategy?
The diamond pattern strategy focuses on breakout trading. It involves identifying the pattern, confirming the breakout with volume or other indicators, and calculating price targets based on its height.
*At FXOpen UK, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules. They are not available for trading by Retail clients.
Read more: https://fxopen.com/blog/en/how-to-trade-the-diamond-chart-pattern/
Text source: Forex Trading Blog
