What is the Diamond Top Formation?

Investing in the securities market requires a combination of technical and fundamental skills. While fundamental analysis aids in evaluating the financial health of a company, technical charts and patterns suggest the entry and exit points for a trade. Diamond Top Formation is one such technical analysis pattern used by traders to predict price movements.

What is Diamond Top Formation?

Diamond Top Formation is a pattern that occurs at or close to the market top position. Typically, the formation indicates the reversal of an uptrend. Diamond Top Formation derives its name from the diamond shape which is formed due to the trend lines of the stock price movement. The peaks and troughs connect when a strong up trending price shows a flattening sideways movement over a prolonged period.

A Diamond Top Formation is fairly unusual. However, it is a convincing indicator of the reversal of an uptrend. This potential reversal provides an opportunity for trades to book sizeable profits. Alternatively, it also provides a short sell opportunity.

Once the neckline of a diamond formation is broken, the technician may predict the reversal. To ascertain the potential move, the trader is required to calculate the difference between the highest and lowest point of the diamond formation and add it to the breakeven point.

How to identify the Diamond Top Formation

Diamond Top Formation occurs when an uptrend ends or is near its end whereas Diamond Bottom Formation occurs when a downtrend ends. Diamond Top Formation generally occurs at major tops with high volumes and rarely at market bottoms. Diamond Bottoms may be compared to the Head and Shoulders reversal pattern which occurs before the Diamond Top Formation. Thus, misidentifying the two may lead to shorting the market prematurely. Diamond Top and Bottom patterns also bear resemblance to Double Tops and Bottoms. However, the latter has distinctive lows and highs.

A diamond pattern can be identified within the head and shoulders or a triangle pattern. Diamond patterns serve as a session to a fresh high and a drop to a support level. Following this, the session attains another fresh high and makes a quick decline which breaks the support level to make an even higher low. The price rebounds from the higher low and is succeeded by a session making a lower high alternatively. Thus, trend lines begin to break into diamond patterns. Upon connecting the initial and subsequent lows and gradual decline, the behavior is spotted.

Similarly, diamond bottoms engage in the same pattern. However, the trend lines begin with a fresh low and fresh high followed by subsequent higher lows and lower highs. Depending upon the time frame of the chart that the trader operates in, the diamond patterns project a period of congestion before the formation of a different trend and trading sentiment.

Characteristics of diamond top formation

Diamond Top Formation has certain salient features which enable the identification of the pattern. These include:

  1. Price Movement: For a Diamond Top Formation, the price movement must be trending upwards. Conversely, in a Diamond Bottom Formation, the price movement is downward leading to the pattern.
  2. Price Action: In a Diamond Top Formation, the price action must resemble a broadening pattern. At the outset, the peaks are significantly higher whereas the troughs are much lower. Further, the price action changes such that the peaks are lower and the troughs are higher.
  3. Identifying Diamond: Up trending and down trending usually include some standard trends which make it easier to identify the pattern. The diamond patterns may be identified by connecting the peaks and troughs. A diamond shape is formed and usually tilted to one side. It will begin with a breakout gap and be followed by several runaway gaps as the price follows its trend.

Diamond Top Reversal Signals

Traders employ a variety of channels to set the upper and lower boundaries around a trend to analyze the volatility ranges of a security’s price and its probable reversal points. Since a diamond top is a powerful indicator for reversal, traders seek to draw a trendline around the pattern which forms a diamond shape. The pattern must continue to trade within the trendline boundaries to be classified as a Diamond Top Formation. If the price movement continues within the boundaries, the trendlines can provide resistance and support levels to help the trader trade into the reversal.

More likely than not, the resistance trendline serves as a reversal point for the price of the security. Hence, analysts carefully observe the patterns at the resistance level of a security price action. The reversal pattern helps the trader to ascertain the price momentum of the security at its resistance level. Although, a reversal trendline does not always indicate a price correction. The stock price may push through the resistance trendline and continue to increase further.

Final Words

In conclusion, a diamond formation is one of the several patterns which is sought out by technical traders. Even though diamond formations are rare, diamond patterns are strong indicators of price movements and are employed by traders to benefit from the price movement. At the same time, traders can predict the entry point, potential move, and exit point before entering into the trade.

Frequently Asked Questions Expand All

It is imperative to maintain a stop loss in a diamond formation. Stop loss must be positioned above the last top inside the diamond for a bearish position and below the last low inside the diamond for a bullish set-up to guarantee profit protection.