Introducing The Bearish Diamond Formation
For years, market aficionados and forex traders alike have been using simple price patterns not only to forecast profitable trading opportunities but also to explain simple market dynamics. As a result, common formations such as pennants, flags and double bottoms and tops are often used in the currency markets, as well as many other trading markets. A less talked about, but equally useful pattern that occurs in the currency markets is the bearish diamond top formation, commonly known as the diamond top. In this article, we'll explain how forex traders can quickly identify diamond tops in order to capitalize on various opportunities.
The diamond top occurs mostly at the top of considerable uptrends. It effectively signals impending shortfalls and retracements with relative accuracy and ease. Because of the increased liquidity of the currency market, this formation can be easier to identify in the currency market than in its equity-based counterpart, where gaps in price action frequently occur, displacing some of the requirements needed to recognize the diamond top. This formation can also be applied to any time frame, especially daily and hourly charts, as the wide swings often seen in the currency markets will offer traders plenty of opportunities to trade.
Identifying and Trading the Formation
The diamond top formation is established by first isolating an off-center head-and-shoulders formation and applying trendlines dependent on the subsequent peaks and troughs. It gets its name from the fact that the pattern bears a striking resemblance to a four-sided diamond.
Let's look at a step-by-step breakdown of how to trade the formation, using the Australian dollar/U.S. dollar (AUD/USD) currency pair (Figure 1) as our example. First, we identify an off-center head-and-shoulders formation in a currency pair. Next, we draw resistance trendlines, first from the left shoulder to the head (line A) and then from the head to the right shoulder (line B). This forms the top of the formation; as a result, the price action should not break above the upper trendline resistance formed by the right shoulder. The idea is that the price action consolidates before the impending shortfall, and any penetrations above the trendline would ultimately make the pattern ineffective, as it would mean that a new peak has been created. As a result, the trader would be forced to consider either reapplying the trendline (line B) that runs from the head to the right shoulder, or disregarding the diamond top formation altogether, since the pattern has been broken.
To establish lower trendline support, the technician will simply eye the lowest trough established in the formation. Bottomside support can then be drawn by connecting the bottom tail to the left shoulder (line C) and then connecting another support trendline from the tail to the right shoulder (line D). This connects the bottom half to the top and completes the pattern. Notice how the rightmost angle of the formation also resembles the apex of a symmetrical triangle pattern and is suggestive of a breakout.