For years, common formations such as pennants, flags and double bottoms and tops have been used by traders in the currency 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.

The diamond top generally occurs at the top of considerable uptrends. It effectively signals impending shortfalls and retracements with relative accuracy and ease. 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 resemblance to a four-sided diamond.

Let's break the process down step-by-step 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. Bottom-side 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 with the top and completes the pattern.

Notice how the rightmost angle of the formation also resembles the apex of a symmetrical triangle pattern and points to a breakout.



Figure 1: Identifying a diamond top formation using the AUD/USD.
Source: FXTrek Intellicharts



Figure 2 below shows a zoomed in view of Figure 1. We can see that a sessioncandle closed below or "broke" the support trendline (line D.i.), indicating a move lower. The diamond top trader would profit from this by placing an entry order below the close of the support line at 0.7504, while also placing a stop-loss slightly above the same line to minimize any potential losses should the price bounce back above. The standard stop should be placed 50 pips higher at 0.7554. In our example, the stop order would not have been executed because the price did not bounce back, instead falling 150 pips lower in one session before falling even further later on.



Figure 2: A closer look at the diamond top formation using the AUD/USD. Notice how the position of the entry is just below the support line (D.i.).
Source: FXTrek Intellicharts



Finally, profit targets are calculated by taking the width of the formation from the head of the formation (the highest price) to the bottom of the tail (the lowest price). Continuing with our example using the AUD/USD currency pair, Figure 3 shows how this would be done. In Figure 3, the AUD/USD exchange rate at the top of the formation is 0.8003. The bottom of the diamond top is exactly 0.7250. This leaves 753 pips between the two prices that we use to form the maximum price where we can take profits. To be safe, you should set two targets in which to take profits. The first target will require taking the full amount, 753 pips, and taking half that amount and subtracting it from our entry price. Then, the first target will be 0.7128. The price target that will maximize our profits will be 0.6751, calculated by subtracting the full 753 pips from the entry price.



Figure 3: The price target is calculated on the same example of the AUD/USD.
Source: StockCharts.com



Using a Price Oscillator Helps
A key to successful trading is to always receive affirmation, and the diamond top pattern is no different. Adding a price oscillator such as moving average convergence divergence and the relative strength index can increase the accuracy of your trade, since tools like these can gauge price action momentum and be used to confirm the break of support or resistance. (To learn more, see Getting To Know Oscillators.)

By applying the stochastic oscillator to our example (Figure 4 below), the investor confirms the break below support through the downward cross that occurs in the price oscillator (point X).



Figure 4: The cross of the stochastic momentum indicator (point X) is used to confirm the downward move
Source: FXTrek Intellicharts



Conclusion
The bearish diamond top is often overlooked because it happens so infrequently, but it is still very effective in displaying potential opportunities in the forex market. When this formation is combined with a price oscillator, the trade becomes an even better catch - the price oscillator enhances the overall likelihood of a profitable trade by gauging price momentum and confirming weakness as well as weeding out false breakout/breakdown trades. (To learn about other tools used in technical analysis, see our Introduction To Technical Analysis tutorial.)


Fibonacci

Related Articles
  1. Trading

    Introducing The Bearish Diamond Formation

    Profit-taking opportunities abound using this lesser-known pattern. Find out how.
  2. Investing

    It's Time To Invest In Diamonds

    For investors looking for additional safe havens to place their money, diamonds could be an interesting bet.
  3. Managing Wealth

    Are Colored Diamonds a Girl's Best Friend?

    These gemstone kings of bling are trendier than ever. How to not get ripped off when buying a diamond.
  4. Investing

    Diamonds: The Missing Commodity Derivative

    While they may be "a girl's best friend", diamonds haven't made it to the futures market - yet.
  5. Investing

    Introduction To Technical Analysis Price Patterns

    To "find your game" in technical analysis, you need to be able to recognize reversals and continuations as they form.
  6. Trading

    Make Sharp Trades Using Andrew's Pitchfork

    This technical indicator is underused in the currency markets, but it can help you isolate profitable opportunities.
  7. Trading

    Using Double Tops And Double Bottoms In Currency Trading

    Find out how to apply the two most common price reversal patterns to your trading.
  8. Trading

    Tweezers Provide Short-Term Precision For Forex Traders

    Precise and short, the tweezer setup is similar to the more popular double top/bottom formations.
  9. Investing

    The Utility Of Trendlines

    Trendlines give an investor a good idea of the direction an investment might move in. Discover how to make them work for your portfolio.
Frequently Asked Questions
  1. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  2. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  3. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
  4. What is the 1003 mortgage application form?

    Learn about the 1003 mortgage application form, what information it requires and why this form is the industry standard for ...
Trading Center