Diamond Pattern Trading: Learn the Basics
Diamond pattern trading isn’t for beginners! Not only are these patterns rare, but also they’re often wildcards, breaking up or down regardless of bullish or bearish indicators. That said, it’s important for every pattern trader to know the basics of a diamond pattern.
Diamonds are volatile and dangerous to trade before they break, which often leaves traders guessing at when to enter or exit a position. Don’t let a diamond’s easy-to-stop nature fool you: They’re dangerous for an experienced trader. But for those who play a diamond right, profits could be substantial.
Recognize Diamond Pattern Trading Trends
Diamonds are well-named because of their appearance on a stock chart. They begin with a big climb or drop in price, followed by a leveling out that’s also marked by contraction. The diamond occurs when the initial contraction begins to swing volatilely before contracting again, right before another big price swing. The problem is, traders can’t know whether the second price swing will be up or down until the break.
The one thing that’s proven about diamonds involves their formation. The longer they take to form, the more explosive the resulting rally or drop. Diamonds that form over 10 to 12 trading periods won’t be as volatile in the break as those that form over 25 to 30 periods.
Why Are Diamond Patterns Important?
Diamond recognition trading revolves around investor psychology, as most patterns do. This pattern looks at a very specific way of thinking that factors into how the stock behaves.
After a large movement, investors are eager either to take profits (bullish) or to short (bearish). This causes the first round of consolidation. Then there’s a period of instability that occurs as investors become emboldened by the volume. The second round of consolidation is a pullback, which serves to restabilize the price. The final breakout occurs when investors seek to capitalize on the current level en masse. Essentially, diamonds signal uncertainty that traders can capitalize on.
Creating certainty during a time of instability can be very lucrative for day traders. Where some might choose to preempt a diamond and set their target price too soon, investors who weather the consolidation in the back half of a triangle are positioned to reap maximum returns.
Common Mistakes in Diamond Pattern Trading
Trading diamonds too early is the biggest mistake a trader can make. Once established, treat the second half of the diamond like a symmetrical triangle and draw support and resistance lines. When the price breaks above or below either threshold, it signals the direction of the impending price movement.
The biggest risk in trading a diamond comes in setting target prices and stop-losses. There’s no conventional or technical way to evaluate just how high or low a diamond’s break will go. Because of this, many traders are either too conservative or too aggressive in their benchmarking (through no fault of their own). The best traders can hope to do is to examine the initial drop or spike that started the diamond and use market momentum to predict the continuation or correction level after the break. Some traders calculate the difference between the high and low points of a diamond and add it to the breakout.
The Final Word on Diamond Pattern Trading
Stock patterns are a great way to indicate price movement. However, this takes experience and countless hours of data research. For up-to-date stock trends, sign up for the Profit Trends e-letter below.
The one takeaway for diamond pattern trading is not to trade against it until it shows you a definitive break. The trend might be bearish, but the break might be bullish; or the trend might be bearish while the break is a drop in price. In either case, it’s virtually impossible to play a diamond formation until it breaks, which makes your window to capitalize on a position very short.