The diamond chart pattern obtains its name from the diamond-like shape it produces on price charts when volatility is expanding and contracting. The diamond can form at either a top in an uptrend, a diamond top, or at the bottom in a downtrend, the diamond bottom.
More commonly associated as a reversal signal that shows at the top of an uptrend, this diamond is also a pattern of some utility in revealing either a bull or a bear move.
The Main Features of a Diamond Chart Pattern Include:
- Expanding Swing Highs and Lows: First, the price action is expanding and creates larger highs and lows.
- Contraction Following Expansion: The pattern starts to contract again, making the diamond shape.
- Breakout Confirmation: The final confirmation comes when the price breaks out of the pattern. It could be either in an upward or downward movement, signaling the reversal.
How to Identify the Diamond Chart Pattern
Proper identification of the diamond chart pattern needs close observation of the price action. Here is how to identify it:
Check for Reversal Contexts
- At the peak of an uptrend, look for swing highs expanding prior to contracting.
- At the bottom of a downtrend, look for the reversal: swing lows expand first before contracting.
Draw Trend Lines
- Connect the very first swing highs and lows to form expanding trendlines.
- As the pattern develops, look for the contracting trendlines that form the diamond shape.
Wait for the Final Stages
- The diamond pattern is only fully confirmed in its later stages when the contraction phase is evident.
Use Technical Indicators for Confirmation
- Indicators such as RSI or MACD can be used to confirm the pattern, showing overbought or oversold conditions and potential reversals.
How to Trade the Diamond Chart Pattern
Trading the diamond chart pattern can be easy with a systematic approach. Here’s how to execute trades based on this pattern:
Entry Points
- For a Diamond Top (Bearish): Enter a short position after the breakout candle closes below the support level.
- For a Diamond Bottom (Bullish): Enter a long position after the breakout candle closes above the resistance level.
Stop Loss Placement
- Place your stop loss above the final swing high for a bearish diamond top.
- For a bullish diamond bottom, place your stop loss below the final swing low.
Profit Target
- The profit target can be determined by using the height of the pattern; that is, the distance between the highest and lowest points within the diamond.
- Alternatively, use a favorable risk-to-reward ratio such as 1:2 or 1:3 to determine your exit strategy.
Example Trade Setup
For better understanding, let’s pick the diamond top example:
- Identification of Formation: A diamond top occurs at the head of an uptrend trend, where the swing tops and bottoms expand and constrict.
- Breakout Confirmation: Upon breaking below the support zone, the bearish price reversal is confirmed.
- Trading: Short position entry signal at the close of breakout candle.
- Stop Losses: Stop losses above the last swing top.
- Profit Target: Target a support level equivalent to the height of the diamond or a calculated risk-reward ratio.
A diamond bottom pattern works in the opposite direction for bullish trades.
Pros and Cons of the Diamond Chart Pattern
Pros
- Versatility Across Markets and Timeframes: The diamond pattern can be seen in Forex, stocks, and commodities and works across multiple timeframes.
- Dual Trading Opportunities: The pattern offers both buying (bullish) and selling (bearish) opportunities.
- Early Trend Reversals: It allows traders to enter early into new trends, maximizing potential profits.
Cons
- Difficulty in Identification: Recognizing the pattern accurately requires experience and careful analysis of price action.
- Limited Use on Short Timeframes: On shorter timeframes, such as 1-minute or 5-minute charts, the pattern may lose its effectiveness.
- Potential for False Signals: In choppy or flat markets, the diamond pattern may produce misleading signals, leading to losses.
Best Practices for Trading the Diamond Chart Pattern
- Wait for Breakout Confirmation: Do not jump into trades too early. Wait for a decisive breakout candle to confirm the pattern.
- Combine with Indicators: Use tools like RSI, MACD, or Fibonacci retracements to validate the breakout and increase accuracy.
- Adopt Risk Management: Always use stop losses and calculate your position size based on your risk tolerance.
- Practice on Longer Timeframes: Focus on daily or 4-hour charts to increase the reliability of the pattern.
Key Takeaways
- Structure and Occurrence: Reversals of uptrends and downtrends occur in diamond patterns by the expansion of two and contraction of two trendlines.
- Trading Opportunities: Bearish reversal or sell signal, and bullish reversal or buy signal are indicated when the diamond top and diamond bottom patterns occur.
- Entry and Exit Strategies: Entry on confirmation of breakout. Using stop losses for protection, entry based on the pattern’s height for profit target setting.
