Diamond Tops and Interpretational Guidelines

by FX EA Review
Diamond Tops and Interpretational Guidelines

Diamond tops are connecting triangular formations in a diamond pattern that depict the reversal/ continuation of an uptrend or a downtrend. As the name suggests, the trendlines (double-V-shaped) connect at the peak (inverted V) and at the trough/bottom of the price of the stock or security before a breakout. While diamond tops can be used to signal an uptrend after some time, they are very effective when traded in a downward/bearish breakout, especially in the short-term. However, for the diamond pattern to be formed, the trend of the price has to be upward so that it also shows a bullish continuation.   

Identifying the diamond-top shape in trading

Diamond top formation

Fig 1: Diamond top formation

The diamond top’s shape is formed based on the market volatility. It starts with a contraction as volatility increases and volume expands. Afterward, as it lowers volatility, contractions begin towards the end.

The lowest point before the uptrend that led to the formation of the diamond-shape was the $20 dollar price. After the diamond pattern is formed, the price moves to $20 before rising again to highs of $23.5 where the diamond top locates. The asymmetrical shape of the diamond is acceptable (as seen in figure 1) due to the movement of price trends.

Unlike the diamond bottom, where prices move downwards when the shape is formed, the diamond top is formed when prices are moving up. If the price breaks on the upside, the trader should trade up, but if it breaks on the downside, the trade is bearish. The longer it takes for the diamond pattern to form, the greater will be the impact on the rally or the drop in price of the security.

Let us look at how to spot gold (XAU) is trading against the US dollar (USD) on February 18, 2021.

XAU/USD - The spot gold/US dollar

Figure 2: XAU/USD – The spot gold/US dollar

In mid-September 2020, the market was trending downwards towards the $1,861.76 mark. Then it started going up in October 2020, gaining the diamond top formation. When the market broke out of the diamond, it started to contract from $1,906.876 on October 28, 2020, to $1,865.23 the following day. From where the diamond top pattern began, the short-term trend is more of a bearish continuation rather than a bullish reversal.

The pattern formed as the price trendline had slightly stopped the downward movement. Additionally, the market was trending upwards before it encountered the down-day, sending prices from a high of $1,950 to a low of $1,850 (-$100).   

Peculiarities

Let us keep in mind that with diamond tops, the previous price before the pattern formed is in an uptrend. The prior upside price was, however, weak in the case of spot gold that makes us see the continuation as bearish for spot gold even in 2021.

In our XAU/USD chart, the breakout goes downwards instead of an upside. This movement translates to a lower trend supporting the dollar against spot gold, especially in the long run. Diamond tops that have a downward breakout (at the end of the pattern) have a higher chance of correctly identifying a bearish price movement. But, if the breakout goes in an upside position, the diamond pattern will depict a bullish trendline for the security under analysis.

The name diamond top should not restrict the trader to only consider trading when the pattern forms at the top of the price chart. It can occur anywhere. However, it is different from the diamond bottom in the fact that the bottom mostly takes shape when the market price is trending close to the year-lows.

The breakout volume for the diamond top is mostly high (either on the upside or downside). This volume can escalate for various days. Support and resistance (SAR) can be spotted in the diamond top formation. This characteristic enables the trader to either buy (at a support) or sell (at a resistance).

Trading recommendations

Let us consider the advanced chart of the XAU/USD, and we will notice emerging trend lines that will affect trading.

Shoulders and Head on the XAU/USD Chart

Figure 3: Shoulders and Head on the XAU/USD Chart

The diamond top pattern has 3 distinct sections – the left shoulder, head, and right shoulder – as it breaks out. In most cases, the head puts the highest resistance; let’s call it R1. The right shoulder gives the second resistance, R2, and the bottom joint shows the third and final resistance. A bearish trader should be cautious when interpreting these three resistance levels as they may also act as support. However, they have a high success rate, as shown in figure 3.

The XAU/USD trading pair faced the highest resistance at R1- $1,951.77 and R2- $1,908.84 and R3 – $1,866.61. In all instances, the prediction occurred exactly as the diamond pattern signaled.

The trader should wait and close (either a bullish or bearish position) outside the diamond pattern’. This patience will enable the trader to identify the price movement of the security. Also, as shown in figure three, it is vital to consider the support (risk) or the resistance (reward) regions before placing the trade. These sections show where the trade may stop or pause pending a reversal or a continuation.

The measure rule is also applicable in the diamond top formation. The trader subtracts the highest high (R1) with R3 – the lowest low in the pattern to get the expected price movement. In our case, the difference is 85.16. The trader can choose to also subtract R1 and R2, which shows the breakout location. A choice will then be made to either move in the upside or downside depending on the trading preference.

Conclusion

This article shows how to identify the diamond top pattern. It has explained how the pattern can be used to describe a continuation or a reversal. It is mostly applied in short-term bullish/ bearish market trends. The diamond top pattern with three parts (head, left, and right shoulders) mostly signals a bearish market trend. The trader identifies the three sections as either support or resistance levels before placing a trade. The main difference between a diamond top and a bottom pattern is that in the former, the prior/ previous price is bullish (except where there is a down-day), but with the latter, the prior price is a downtrend.

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