Diamond Formation

Market traders have been using simple price patterns to forecast profitable trading opportunities and explain market dynamics. We have covered chart patterns like, Broadening tops, Trend channels and Island Reversals. Today we will look at the “diamond pattern” formations. The diamond pattern is found rather infrequently.

Diamond patterns usually form over several months in very active markets. Volume will remain high during the formation of this pattern. A diamond pattern is considered a two edged sword, because, if it breaks to the downside it suggests lowering prices, conversely, if it breaks on the upside it suggests continuing higher prices. A diamond pattern forms because prices create higher highs and lower lows in a broadening pattern. Then the trading range gradually narrows after the highs peak and the lows start trending upward. The technical event occurs when prices break upward (or downward), out of the diamond formation, which suggests the breakout, up (or down), will continue for a while.

Diamond Formation in Commonwealth Bank (CBA) Chart
As you can see below from Commonwealth Bank (CBA) daily chart from July 2006, there has been a pattern forming that complies to the 'Diamond' rules. It demonstrates widening with a higher high (1), a lower low (2) and then narrowing with a lower high (3) and a higher low (4) before it broke (5)

The diamond top formation is established by first isolating an off-centre head and shoulders formation and applying trendlines dependent on the subsequent peaks and troughs. Generally, a short position is taken when the price falls below the lower ascending trendline, once the trendline has been broken the price targets are usually set to be equal to the entry price minus the distance between the top and the bottom of the pattern. When the price breaks through the higher descending line (bullish) the price target is the entry price plus the distance between the top and the bottom of the pattern.