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.

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

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.)


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