What Is a Diamond Top Formation?
A diamond top formation is a technical analysis pattern that often occurs at, or near, market tops and can signal a reversal of an uptrend. It is so named because the trendlines connecting the peaks and troughs carved out by the security's price action form the shape of a diamond.
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.
- A diamond top formation is a chart pattern that can occur at or near market tops and can signal a reversal of an uptrend.
- A diamond top formation is so named because the trendlines connecting the peaks and troughs carved out by the security's price action form the shape of a diamond.
- Technicians suggest that to calculate the potential move, once the neckline of a diamond formation is broken, the trader should calculate the distance between the highest and lowest point in the diamond formation and add it to the breakout point.
Understanding Diamond Top Formations
Diamond top formations are generally uncommon. However, when they do form, they can be a strong indicator for an impending reversal of the current uptrend. This pattern occurs when a strong up trending price shows a flattening sideways movement over a prolonged period of time that forms a diamond shape.
Technical traders are always on the lookout for potential reversals, as they offer the opportunity for sizable profits, which makes the diamond top formation quite a potent pattern. Technicians suggest that to calculate the potential move, once the neckline of a diamond formation is broken, the trader should calculate the distance between the highest and lowest point in the diamond formation and add it to the breakout point.
Most diamond top formations will exhibit the following characteristics:
- The security's price should be trending upward.
- Price action should then start resembling a broadening pattern, where the peaks are higher and the troughs are lower, at the onset.
- Subsequently, the price action changes to where the peaks are lower and the troughs are higher.
- Connecting the peaks and troughs will form a diamond, usually tilted to one side.
Diamond top formations will only occur at the end of an uptrend while their counterpart, the diamond bottom formation, occurs at the end of a downtrend. Diamond top formations can be confused with the more popular, and more powerful, head and shoulders formations.
Traders should be wary of making this mistake as the diamond top formation generally occurs before the head and shoulders reversal pattern. Misidentifying this could cause traders to short the market prematurely. Diamond tops and bottoms can also generally be comparable to double tops and bottoms, but they tend to have less distinctive highs and lows.
Trends and Reversals
Technical analysts typically seek to identify defined trends and subsequent reversals as these patterns usually provide the most profitable trading signals. Up trending and down trending prices usually include some standard patterns that help to make trends more easily identifiable. Most trends will begin with a breakout gap and be followed by several runaway gaps as the price follows its trend.
Traders will use a variety of different types of envelope channels that set upper and lower boundaries around a trend for the purpose of understanding the volatility ranges of a security’s price and its potential reversal points. Since security prices generally oscillate over time, channel boundaries can be a good tool for providing an indication of the points at which a reversal may occur.
When the diamond top 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 weaknesses as well as weeding out false breakout/breakdown trades.
Diamond Top Reversal Signals
Diamond tops typically form at the end of an uptrend which makes them a powerful signal for a reversal. Usually, these patterns will look similar to an off-center head and shoulders pattern or a flattened double top pattern.
Traders identifying a potential diamond top will seek to draw trendlines around the pattern which form a diamond shape. The pattern must continue trading within the trendline boundaries to be classified as a diamond top. If the price action remains within the boundaries, the trendlines can provide isolated resistance and support levels that can help a trader to trade into the reversal.
Technical traders watch for patterns forming at a security price’s resistance trendline. Oftentimes, the resistance trendline will serve as a reversal point for the security’s price. However, it can also be common for the price to move through the resistance trendline and continue pushing higher.
Diamond top reversal patterns are one of several trend reversal patterns that can help a trader determine a security’s price momentum at its resistance level. Generally, most technical traders will seek to identify strong technical patterns such as a diamond top reversal at a security’s resistance level before betting on the security’s price movement. If a diamond top reversal is detected, then a trader will likely sell, or short sell, to profit from a new downtrend formation.