Diamond Pattern in Trading - Formation and Key Features
By Stelian Olar, Updated on: Feb 04 2024.
A diamond top pattern is a reversal chart pattern that forms during a clear uptrend or downtrend, indicating a potential trend reversal ahead. Though not as widely known as triangles or head and shoulders, understanding advanced technical formations like diamond patterns can unlock profitable trades with high-probability reversal trade setups when identified early.
Unlike the more common head and shoulders pattern, diamond tops and bottoms have four points that converge to a narrow middle, forming the distinct diamond shape that gives the diamond formation its name.
The diamond chart pattern starts taking shape when the asset's price action hits a new high or low, then pulls back to form the first point. The second point occurs when the price exceeds the previous high/low before falling back.
This process repeats to carve out the signature diamond shape.
The key to trading diamond pattern stocks starts with quickly detecting when those angled trendlines are forming, signaling consolidation before a powerful move. A diamond top occurs at market peaks, while diamond bottoms form at market lows, but the difference between the two is critical for applying the right trading strategy.
We’ll explore everything from spotting diamond bottom and diamond top Forex to trading strategies after the breakout.
More, in this comprehensive guide, we’ll cover:
- Defining diamond chart patterns and their common structure
- Distinguishing diamond pattern trading bullish or bearish from other common formations
- Identifying diamond reversals - tops and bottoms
- Using indicators like volume for diamond pattern trading
- Trading breakouts from diamond continuations or reversals
- Managing risk with stop losses and profit targets
- Examples of diamonds on real price action charts
- Tips for consistently profiting from this trend reversal pattern.
Let’s get started…
What Is the Diamond Pattern in Trading
The diamond pattern is a relatively uncommon yet highly reliable reversal pattern that can signal major price movement changes in the markets (stock market, Forex market, cryptocurrency market, etc.). It forms slowly over time as a security's price action carves out four distinct highs and lows that converge towards the middle, creating a diamond shape from the support lines and trendlines connecting each swing point reflecting decreasing volatility.
Classic market theory states that technical analysis patterns like the diamond reversal pattern represent a "struggle" between buyers and sellers that eventually resolves with an explosive move out of the formation after the equilibrium breaks down. In the case of diamond tops and bottoms, the end result is often a powerful reversal from the prior uptrend or downtrend.
Diamond chart patterns belong to the family of classical chart formations used in technical analysis, along with more widely known figures like:
But relative to other common structures, the diamond stock pattern doesn’t emerge on the price charts nearly as often.
When these relatively rare diamond trading pattern setups do take shape, however, they can provide swing traders with extremely useful early warning signs of trend reversals ahead.
Bullish Diamond Pattern in Trading
The bullish diamond pattern, sometimes referred to as a diamond bottom pattern, forms during a clear downtrend signaling the potential end of the broader downward momentum, offering traders an opportunity to enter a long position in anticipation of an eventual upside breakout.
Visually, the bottom diamond pattern looks like a stretched-out inverted head and shoulders pattern. The formation builds as the price first drops to carve out a low, then recovers somewhat before making a lower low.
This process repeats to create four distinct troughs and peaks which comprise the “diamond”.
The most critical part of this bottom pattern comes once the security's price breaks up through the upper trendline with increased momentum, validating the diamond as a true reversal signaling more upside is likely ahead. Savvy traders will look to use this resistance breakout in the downtrend to join the emerging rally.
Example of a Bullish Diamond Pattern
Bearish Diamond Pattern
The bearish version of the diamond pattern, sometimes called “diamond tops" takes shape at the end of a strong uptrend and it signals potential exhaustion of the preceding uptrend. Visually the diamond pattern top looks similar to the head and shoulders pattern.
The pattern reaches completion when the price breaks down through the lower support trendline that makes up the bottom of the diamond formation.
For traders, this breakdown can provide a strategic opportunity to enter a short position in anticipation of further downside. The completion of this topping bearish diamond pattern indicates the upside momentum has likely stalled out, paving the way for a reversal to the downside.
Example of a Bearish Diamond Pattern
What Is the Diamond Pattern Strategy
Strategically planning entries for the eventual breakout or breakdown is key to effectively trade the diamond pattern effectively. When a diamond pattern chart starts to form during a trend, traders who are paying close attention can look for opportunities to enter trades when the price breaks out of key support and resistance levels within the pattern betting on trend reversals or trend continuations.
Specifically, the diamond pattern trading strategy revolves around watching for two types of signals:
- Reversal Trades - A break below support in an uptrend, or alternatively a break above resistance in a downtrend, signals the trend is likely reversing.
- Continuation Trades - If support or resistance holds after an initial test, this confirms the trend is continuing. Enter a trade in the overall trend direction as continuation plays out.
In both cases, the diamond acts as an early indicator for planning potential reversal or continuation moves before they fully develop.
Strategically targeting entries during key breakouts with stop-losses contained behind key levels allows nimble traders to capitalize on high-probability opportunities in either direction.
Diamond Pattern at the Top and Bottom
When a diamond pattern forms at the top of a trend, traders can prepare to sell the eventual breakout below the pattern's lower trendline, signaling major distribution and a potential trend reversal. The opposite is true for diamond bottom pattern trading ending downtrends.
In both cases, combining the diamond pattern stock with other indicators paints a clearer picture. For example, overbought RSI divergences confirm diamond top or you can time entries with momentum indicators like increasing volume.
Diamond Pattern vs. the Head and Shoulders Pattern
At first glance, diamond tops and the popular head and shoulders pattern appear quite similar. Both feature distinctive peaks and troughs that converge towards the middle before breaking out but despite the visual commonalities between a stock diamond pattern and head and shoulders on charts, there are some key structural differences between these formations:
- Symmetry - The inversion points of diamonds form in very symmetrical arcs converging to the middle. Meanwhile, head and shoulders patterns feature one dominant "head" peak flanked by two smaller "shoulders".
- Duration - Diamonds tend to play out faster over shorter periods of time as the series of peaks and troughs form the pattern while head and shoulders take more time.
- Rarity - Due to the extended consolidation required to form the "diamond shape pattern" with four clear highs/lows, diamonds appear much less frequently compared to head and shoulders.
- Breakouts - With head and shoulder patterns, breakouts come quite quickly after the right shoulder forms. With diamond top pattern trading formations, however, the eventual breakouts are less abrupt as they emerge from the tighter consolidation.
How to Trade the Diamond Chart Pattern
When an emerging bullish diamond pattern trading is identified, there are some key steps for executing high-probability diamond pattern trade setups that you can follow:
- Identify the Opportunities: Closely monitor charts to detect developing diamond tops or bottoms by drawing the key support lines connecting the peaks and troughs.
- Mark Likely Breakout Levels: Project where resistance or support levels are likely to break based on the diamond shape pattern trading formation.
- Prepare Pre-Breakout: Plan the pattern trade that will trigger on a definitive break of support in a diamond top (or resistance in a diamond bottom).
- Diamond Pattern Trading Target: A common method is going long at the breakout level in a bullish diamond pattern and targeting gains equal to the height of the diamond or the distance between the highest and lowest points. Use multiples of this "measured move" to project upside price targets.
- Use Stop Losses: Employ tight stop losses when entering on breaks until the new trend direction proves valid. Stops help neutralize risk if a breakout fails.
Proactively planning diamond pattern trades in advance leads to precision execution and you’re more likely to see the price reaching the profit target you’re aiming for.
Now that you understand the diamond chart pattern and how to trade it, you may be looking for a broker who provides the tools and technology to help you effectively analyze charts and capitalize on emerging technical formations like these.
Pepperstone offers leading trading platforms with customizable charts and technical indicators needed to identify patterns and execute precision trades. US residents can try eToro which is readily available for both new and experienced traders as they develop their trading skills.