What is the Diamond chart pattern, and how to trade it

What sets the Diamond pattern apart? It's a rare gem on charts, often overlooked by traders. Yet, this uniqueness may make it a valuable tool in trading. This article will give you an exclusive insight into this less common but potentially powerful trading tool. You'll find out how to spot it and what advantages and disadvantages come with using it in trading.

What is the Diamond pattern?

The Diamond chart pattern is a technical analysis tool widely used by traders in different financial markets. It is also used as a breakout trading strategy. Diamond patterns usually provide insights into potential breakouts and trend reversals. They can be bullish or bearish. The example below shows both structures of the Diamond pattern.

A Bullish Diamond pattern forms when the market is bearish, thus signalling a potential reversal.

A Bearish Diamond pattern forms when the market is bullish, signalling a potential reversal.

Diamond patterns, especially on longer timeframes, are known for their reliability. In shorter timeframes, they are more likely to produce false signals, but with the right understanding, you can still use them effectively.

How does the Diamond chart pattern work?

The Diamond pattern occurs after either a bullish or bearish market. The market consolidates at the peak, indicating equal buying and selling pressure. The pattern signifies losing momentum on a trend, thus a potential reversal. The market forms a distinct diamond shape.

The pattern completes only when the price exceeds the upper or lower trendlines. Suppose the breakout occurs above the upper trendline. In that case, it suggests that bulls have regained control, indicating that traders should consider entering new long positions. Conversely, a breakdown below the lower trendline signals that bears have overwhelmed demand, likely leading to a bearish trend.

Diamond patterns are more distinct on real-time trading charts than in diagrams. But if the pattern follows the logic of highs and lows and is more or less diamond-shaped, it is a Diamond.

Key characteristics

The table below summarises the essential features that define this pattern.

Types of the Diamond chart pattern

There are two types of Diamond patterns. They are easy to identify visually, but it is essential to comprehend what each one means.

Diamond Bottom (Bullish)

The Diamond Bottom pattern is a bullish signal. It indicates a reversal from downward (bearish) momentum to upward (bullish) momentum. Let's look at the following case.

The market has been in a downtrend for several weeks. Over two months, the price began to stabilise, forming a distinct diamond shape on the chart. The pattern developed as the price created lower highs and higher lows.

The upper trend line connects these lower highs, and the lower trend line connects the higher lows, illustrating increasing volatility. During the consolidation phase, trading volume decreases, indicating weakening selling pressure. The volume increases as the price approaches the breakout point, signalling potential bullish interest.

A breakout occurs when the price closes above the upper trend line (at 1.1800) with a noticeable surge in volume. This breakout indicates that buyers have taken control, suggesting a reversal of the downtrend to a bullish phase.

You enter a long position at 1.1825, set a target at a significant resistance level of 1.2000, and place a stop loss at 1.1750. As momentum builds, the price rises to the target of 1.2000, allowing you to lock in profits.

For example, the breakout to the upper side indicates a potential bullish trend in a bullish diamond. Thus, traders ought to look for long entries.

Diamond Top (Bearish)

A Diamond Top is a bearish reversal pattern that appears after an uptrend. It signals a potential price decline as the market transitions from bullish to bearish.

The formation consists of two symmetrical triangles that converge, and higher and lower lows characterise them. Initially, the price makes higher and lower lows, reflecting a struggle between buyers and sellers. As the pattern develops, volatility decreases, indicating indecision among traders. A breakdown below the lower trendline confirms the reversal, prompting traders to consider short positions.

To illustrate a Diamond Top pattern, let's take the EURUSD currency pair. It has been trending upwards for a few weeks, reaching a high of around 1.1500. The price makes higher highs and lower lows, creating the left side of the Diamond. It rises to 1.1500, then pulls back to 1.1400, followed by another high at 1.1550 and another low at 1.1450.

As the pattern progresses, volatility decreases, narrowing the price range. On the right side of the Diamond, the price forms lower highs at 1.1520 and higher lows at 1.1460. The pattern is complete when the price breaks below the lower trendline at around 1.1450. This breakout signals a potential bearish reversal.

Upon confirming the breakout below 1.1450, traders enter a short position. To manage risk, they place a stop-loss order above the last swing high—around 1.1550. We can calculate Profit targets by measuring the height of the Diamond formation (the distance between the highest point and lowest point) and projecting this downward from the breakout point.

If executed correctly, this strategy can yield significant profits as the price declines following the breakout, potentially reaching targets based on the initial height of the Diamond pattern.

1. Bullish trend
2. Breakout of Diamond pattern
3. Target

Diamond Continuation

A Diamond Continuation pattern occurs when price action forms a diamond shape but continues in the same direction after the formation. It acts as a pause before the price resumes its original trend.

Let's model the following Diamond pattern Forex example. The GBPJPY pair has been in a strong uptrend for a few weeks. After reaching a high of 150.50, the price begins to consolidate and forms a Diamond Continuation pattern over three weeks.

The price action shows a series of higher and lower lows, creating a symmetrical diamond shape. The upper trendline connects the higher highs, while the lower trendline connects the lower lows, indicating a temporary pause in the uptrend.

During this consolidation, trading volume gradually decreases, reflecting a slowdown in momentum. However, as the pattern approaches completion, volume may spike slightly, indicating traders are positioning themselves for the next move.

A valid breakout occurs when the price closes above the upper trend line at 150.30 with considerable volume. This means that bullish momentum is resuming. You enter a long position at 150.35, setting a target at the previous high of 150.50 and placing a stop loss at 149.50 to manage risk. As the bullish momentum resumes, the price quickly rises to the target of 150.50, which allows you to secure profits.

How to identify the Diamond pattern

To trade the Diamond pattern, follow the plan below:

1. Look for trend context. Identify whether the market is in an uptrend or downtrend. This context will help you determine whether you want a Diamond Top or Bottom.
2. Draw trendlines. Connect the swing highs and lows with trendlines to visualise the converging shape of the Diamond. The pattern should have four key points: the top, two midpoint highs/lows, and the bottom tip. Ensure that both trendlines have similar slopes and lengths for symmetry. Avoid irregular Diamonds without clear trendlines.
3. Monitor volume. Watch for decreasing volume as the pattern forms, followed by an increase in volume at the breakout point to validate the pattern.
4. Confirm breakout. Wait for a clear breakout above or below the trendlines to confirm the new trend's direction. This breakout should be accompanied by increased volume to reinforce its validity.
5. Use additional indicators. Consider using other technical indicators, such as RSI or moving averages, alongside the Diamond pattern to enhance confirmation and trading decisions.

How to trade using the Diamond pattern

To effectively trade using the Diamond pattern, traders should follow a structured approach encompassing identification, confirmation, entry, and risk management. Here's a detailed guide on how to trade this chart pattern.

1. As the Diamond forms, watch for increasing volume. This indicates a possible breakout. Use indicators like moving averages or RSI to see if the trend is weakening. Look for candlestick patterns that show indecision, like Dojis. Check other technical factors, such as Fibonacci levels, for extra confirmation. As mentioned above, only shallow Diamonds have clear support and resistance.
2. When a Diamond pattern breaks out, measure from the bottom tip to the center to estimate price targets. Based on past resistance and Fibonacci extensions, identify potential upside targets. Set stop losses below the lower trendline to manage risk. Determine your position size based on the pattern's height and your risk tolerance. Set alerts to monitor critical levels.
3. Enter the trade when the price breaks above the upper trendline with increasing volume. You can use a market order or place a limit order slightly above. Consider entering again if the price retests the broken trendline. Set a stop loss 3–5% below the lower trendline to protect your investment.
4. After a breakout, adjust your stop loss below key support levels as the trade becomes profitable. Take partial profits at least at a 1:1 ratio compared to your risk. Use trailing stops around Fibonacci extension levels. Stick to your trading plan and avoid letting emotions affect your decisions during this process.

Potential benefits and risks

The Diamond pattern is rare but highly significant, as its advantages are undeniable.

• This pattern offers early indications of potential trend reversals.
• Although infrequent, the Diamond pattern is considered reliable due to its unique structure.
• It provides clear guidelines for determining entry and exit points.
• It enhances risk management strategies.
• The Diamond pattern can be used in various markets.
• It reflects a period of indecision in the market where neither buyers nor sellers dominate, helping traders gauge market sentiment and prepare for potential breakouts in either direction.

Why can you only partially rely on this pattern and use it with other tools? Because, like other trading tools, it could be better. Let's have a look at its disadvantages.

• The Diamond pattern is rare compared to chart patterns like Flags or Head and Shoulders.
• Recognising this structure can be challenging, especially for novice traders.
• It can produce false breakouts, where the price appears to break out of the pattern but then reverses direction.
• Different traders may interpret the same price action differently, leading to inconsistencies in identifying the pattern and determining entry and exit points.
• Due to increased market noise and volatility, the Diamond pattern tends to be less effective on shorter timeframes.
• The instrument's effectiveness can diminish in highly volatile or illiquid markets, where price fluctuations may not reflect market sentiment.
• Setting appropriate stop-loss levels can be difficult because of the potential for false breakouts and rapid price movements.

Final thoughts

• You won't often see the Diamond pattern on the charts, but that doesn't diminish its importance and benefits. It indicates potential market reversals or continuations.
• This structure can appear at market tops, known as a Diamond Top, or at bottoms, referred to as a Diamond Bottom.
• Diamond Continuation pattern arises when price action creates a diamond shape while moving in the same direction following the formation.
• Diamond patterns tend to be more reliable on longer timeframes.
• Combining the Diamond pattern with other tools is crucial in Forex trading, as this practice will provide more reliable signals.