Successful forex trades require the use of trading strategies that are based on signals or indicators that are proven and tested. Reversal indicators play a crucial role in helping a forex trader decide their next trade action. These indicators reflect a change in the direction of the price trend, whether positive or negative, and can be used to identify a correction in the market. Diamond shaped patterns are a type of reversal pattern that are used to signal the end of an uptrend or a downtrend. And like their physical counterparts in nature, diamond patterns can be found by identifying a period in which the price trend of a currency pair starts to widen first and then begins to narrow. Once the pattern has been identified, a trader can use it to take a short position when the price falls below the lower ascending trendline.
These reversal patterns represent movements that form a diamond shape, wherein the first step is a rally to a new high with a drop to a support level, followed by a rally to a newer high and a quick decline, breaking the support level to make a higher low. This is followed by a bounce and a rally, but a lower high. This market behaviour is followed by prices breaking the trend line that connects the first and the second low and declining further.
Similarly, a diamond bottom is formed when prices make a new low and a new high, followed by subsequent higher low and lower high. These patterns exhibit the overall trading sentiment and mood before the emergence of a new trend. Although rare, these patterns can be found within head and shoulder patterns or triangle patterns.
The easiest way to identify diamond patterns is to search at the top of a trend or at the bottom of a trend. The diamond shape of these patterns is a result of the short-term trend lines that connect the peaks and troughs within the price action. This pattern is deemed successful when the price breaks out of the established trend lines.
Factors that lead to the formation of Diamond Tops and Bottoms are uncommon. These patterns are sometimes also confused with head and shoulder patterns, which may or may not contain the diamond top or bottom. The two types of patterns can be differentiated by the fact that most head and shoulder patterns do not have significant swings in trading volumes, while Diamond Tops are generally accompanied by decreasing volume in the second half.
An important feature of a Diamond Top is that the volume corresponds with the size of the trading range, increasing as the price rises and the range peaking near the high price point. The downward trend that follows this is an indication of reduced enthusiasm amongst traders about the specific currency pair. This narrowing range in the second half of a diamond pattern can be represented by a descending resistance level and ascending support, which is a critical breakout point. Traders should look out for this line to be crossed before accepting that the trend is going to move downwards. The risk of false breaks in such patterns can be reduced by confirming the reversal trend by using other indicators.
Diamond Top patterns are quite rare, but when they occur they are a good indicator of a reversal in trend. To reap the maximum benefits of this indicator, it is important to identify them correctly (checking that trading volumes are huge and the pattern is more horizontal), and not mistaking them with head and shoulder patterns (which are more vertical). And lastly, confirm the trend reversal by using at least one other indicator as well.
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