Introducing The Bearish Diamond Formation

For years, market aficionados and forex traders alike have been using simple price patterns not only to forecast profitable trading opportunities but also to explain simple market dynamics. As a result, common formations such as pennants flags and double bottoms and tops are often used in the currency markets, as well as many other trading 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. In this article, we'll explain how forex traders can quickly identify diamond tops in order to capitalize on various opportunities.

The diamond top occurs mostly at the top of considerable uptrends. It effectively signals impending shortfalls and retracements with relative accuracy and ease. Because of the increased liquidity of the currency market, this formation can be easier to identify in the currency market than in its equity-based counterpart, where gaps in price action frequently occur, displacing some of the requirements needed to recognize the diamond top. 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 striking resemblance to a four-sided diamond.

Let's look at a step-by-step breakdown of how to trade the formation, 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. Bottomside 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 to the top and completes the pattern. Notice how the rightmost angle of the formation also resembles the apex of a symmetrical triangle pattern and is suggestive of a breakout.

Figure 1 - Identifying a diamond top formation using the AUD/USD.

Trading the diamond top isn't much harder than trading other formations. Here, the trader is simply looking for a break of the lower support line, suggesting increasing momentum for a probable shortfall. The theory is quite simple. Both upper resistance and lower support levels established by the right shoulder will contain the price action as each subsequent session's range diminishes, suggestive of a near-term breakout. Once a session closes below the support level, this indicates that selling momentum will continue because sellers have finally pushed the close below this significant mark. The trader will then want to place his/her entry shortly below this level to capture the subsequent decline in the price. This approach works especially well in the currency markets, where price action tends to be more fluid and trends are established more quickly once a certain significant support or resistance level is broken. Money management would be applied to this position through a stop-loss placed slightly above the previously broken support level to minimize any losses that might occur if the break is false and a temporary retracement takes place.

Figure 2 below shows a zoomed in view of Figure 1. We can see that a session candle 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 will 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.).

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). Staying 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, the trader will 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
One of the cardinal rules of successful trading is to always receive confirmation, 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.  Applying the stochastic oscillator to our example (Figure 4), 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.

Putting It All Together
Not only do bearish diamond tops form in the major currency pairs like the Euro/U.S. dollar (EUR/USD), the British pound/U.S. dollar (GBP/USD) and the U.S. dollar/Japanese yen (USD/JPY), but they also form in lesser-known cross-currency pairs such as the Euro/Japanese yen (EUR/JPY). Although the formation occurs less in the cross-currency pairs, the swings tend to last longer, creating more profits. Let's look at a step-by-step example of this using the EUR/JPY:

1) Identify the head and shoulders pattern and confirm the offset nature of the formation by noticing that the head is slightly to the left, while the tail is set to the right.

2) Form the top resistance by connecting the left shoulder to the tip top of the head (line A) and the head to the right shoulder (line B). Next, draw the trendlines for support by connecting the left shoulder (line C) to the tail and the tail to the right shoulder (line D).

3) Calculate the width of the formation by taking the prices at the top of the head, 141.59, and the bottom of the tail, 132.94. This will give us a total of 865 pips of distance before we can take our full profits. Divide by two and our first point to take profits will be 432 pips below our entry.

4) Establish the entry point. Look to the apex of the right shoulder and notice the point where the candle closes below the support line, breaking through. Here, the close of the session is 137.79. The entry order should then be placed 50 pips below at 137.29, while our stop-loss order will be placed 50 pips above at 137.79.

5) Calculate the first take profit price by subtracting 432 pips from the entry. As a result, the first profit target will be at 133.45.

6) Finally, confirm the trade by using a price oscillator. Here, the stochastic oscillator signals ahead and confirms the opportunity as it breaks below overbought levels (point X).

If the first target is achieved, the trader will move his/her stop up to the first target, then place a trailing stop to protect any further profits.

Figure 5 - A different example of a diamond top formation using the EUR/JPY cross-currency pair. This chart shows all the trendlines, the highest and the lowest price, and the price target. 


Conclusion
Although the bearish diamond top has been overlooked due to its infrequency, it remains very effective in displaying potential opportunities in the forex market. Smoother price action due to the enormous liquidity of the market offers traders a better context in which to apply this method and isolate better opportunities. 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.

Richard Lee is a currency strategist at Forex Capital Markets LLC. Employing both fundamental models and technical analysis applications, Richard contributes regularly to DailyFX and Bloomberg. He has extensive experience in trading the spot currency markets, options and futures. Before joining the research group, Richard traded FX, equity and equity derivatives for a private equity consortium. Richard graduated from Pennsylvania State University with a Bachelor of Arts in economics and a Bachelor of Science in French with an emphasis in international business.

Profiting With Gartley Patterns

Bearish Gartley

 

Bearish Gartley: A Recent Example

Bullish Gartley

 

A Recent Example of a Bullish Gartley Pattern

So why does this pattern work so well?

This is purely opinion, but as you look at the pattern construction there are two key elements to the success of this pattern. 

Let’s put it in the context of a Bullish Gartley Pattern: 

A)   You are trading with the overall trend. Note that the move from X to A is a large move up, and that the move against the trend from A to D is counter to that of the XA move, but is contained within XA so the trend up is not broken. In fact, in Elliott Wave world the translation of this pattern is that we have one Impulse wave up from X to A, then three corrective moves to the downside (AB, BC, and CD). The conclusion then from Elliott Wave would be the likelihood for another impulse wave to the upside. 

B)   Secondly, the reason this pattern is successful is that it is a bit of a “trap.” Let’s look at this step by step from swing point A.

a.   After establishing swing point A price drops down to B and forms a swing low. Psychologically traders see this as a defining point and start to accumulate positions on the long side. 

b.   As price climbs and forms a swing high C the positions are established and many stops are placed under the swing low B point. In fact, short sellers are even starting to look at this swing B point as a potential area to short if price comes back down. 

c.   As the pattern plays out and price starts coming down from swing high C, the longs are getting nervous and the shorts and sitting in the background ready to pounce. Then Whammo! Price goes below the swing low B and all of a sudden the weak long traders start selling and the short players begin to sell ‘em creating additional momentum to the downside that ultimately takes us down to ideally around the .786 retracement of swing XA. This is a defining point for the stock/commodity. This is where the Gartley pattern screams to look for opportunity to buy…why? Partly due to the fact that you are psychologically going against the market at this point. 

d.   If swing D holds above X and price starts to creep up traders get a little uptight. Then as price goes back above swing low point B the weak short players cover and the longs that got shook out come back in and you’re long position is enjoying the ride from this psychological shake out. 

So, to conclude, the pattern has been successful for so many years, in my opinion because it trades WITH the trend (in the context of the XA move), AND it capitalizes on the psychological aspects of traders.  This is a pattern that I think every trader should be aware of and in many cases should incorporate into their trading plan. Derrik Hobbs

 

Surf's Up With Filtered Waves

In 1977, long before investment analysis software made testing strategies a painless process, market researcher Arthur Merrill manually tested the idea of "filtered waves". Several years later, Martin Zweig popularized the concept as a trading model in his 1986 book, "Winning on Wall Street". In this article, we'll introduce you to this simple trading strategy and illustrate why every active trader should consider paddling out to catch these waves. What are Filtered Waves? Very few people read Merrill's short book, "Filtered Waves, Basic Theory: A Tool for Stock Market Analysis", when he completed it, but this work clearly demonstrated that legendary trader Jesse Livermore's swing trading methods worked. A Wall Street legend, Livermore had detailed his methods of swing trading late in his trading career and was able to make a complex subject understandable to all. While Livermore traded on a short time frame, Merrill discovered that with an appropriate filter, this strategy could form the backbone of long-term investing strategies. Swing trading is a strategy that involves holding a stock overnight, and at times for longer periods. With filtered waves, trades can last for months, and occasionally years. The goal of both methods is to take the low-risk gains from the middle of a trend, rather than trying to pick bottoms and tops. The idea is shown in Figure 1. The swing trader would hold this stock during the time indicated by the dashed line, buying after the bottom is confirmed and selling after the top is confirmed. Figure 1: A wave In Figure 1, the buy signal occurs when the price moves above the previous high. The sell signal is tougher to define; it can be a rule that sells after three days without a new high, or a decline equal to a percentage retracement of the previous move (for example, selling when the stock gives back half of the gains made on the upside). Livermore defined swing buying and selling signals in percentage terms. First, Livermore identified the trend as up or down. An uptrend is a series of higher highs and higher lows; a downtrend is marked by lower lows and lower highs. During an uptrend, Livermore's system only takes long trades. The specific buy and sell points are illustrated in Figure 2. As the uptrend runs its course, prices will eventually experience a decline of at least 4% from a high (Point A in Figure 2). This is the signal to close long trades. When price penetrates the previous swing low by 2% (B), Livermore entered short position. Shorts were closed when prices rose 4% from a recent low (C) and new longs were initiated only after the previous swing high was exceeded by 2% (D). This is also the point where Figure 2 started, with the buy signal shown on the left side of the chart. Figure 2 - Trading the waves However, Livermore never offered proof that his tactics worked. Merrill picked up where Livermore left off, and quantitatively tested the idea of buying and selling based on percentage moves. He simplified the rules, backtesting on the Dow Jones Industrial Average, switching from long to short whenever price rose or fell by 5%. Merrill's results showed that despite a lot of losing trades in trendless markets, these rules beat a buy-and-hold strategy. The name filtered waves comes from the idea that the market moves in waves. These waves ebb and flow just like ocean waves. Up waves are followed by down waves and they all come in different sizes and strengths. Merrill ignored the minor waves, filtering out any moves of less than 5%. The filter allowed him to identify the long-term trend, and formed the basis of a trend following trading system. Building a Trading Strategy Zweig extended the work of Merrill by providing a complete trading history in his book, crediting Ned Davis with developing the trading rules. Using the Value Line Index, a popular trading vehicle at that time, buy signals were generated whenever prices closed 4% above the most recent low. Sells occurred when prices declined 4% from previous highs. From 1966 until 1993, the period Zweig tested in his book, the strategy significantly outperformed the buy-and-hold investor. Taking both short and long trades, Zweig reported that this simple rule posted a 12.6% annualized gain, compared to a 2.7% gain for the index. The system was also profitable on long-only trades, switching to cash instead of shorting the market. Of course, this system can still lose. For example, if we take a trade at the beginning of a bull market, the averages may increase by 20%. This would lead to a trade with a profit of 12%, because entry is delayed until the market has gained 4% and an additional 4% of profits are given back before the sell signal is taken. While this would be a respectable trade, most swing moves are smaller than that. On a 10% move, the trader would show a profit of only 2% before trading costs are considered. On a 5% move, the trader would actually lose 3% or more after trading costs are considered. Advanced Trading Strategies Traders can think of filtered waves as a trend identification tool rather than a standalone trading strategy. While the results are certainly impressive, in a trading range market, the patience and equity of most traders will suffer. Simple modifications to the basic idea should help reduce the risks of being caught in a series of whipsaw trades. Using asymmetrical signals is one way to limit the size of drawdowns. This means setting the buy and sell points at different percentages. Ned Davis Research has published impressive results for the S&P 500. The rules are to buy when the index rises by 8.4% from an extreme low closing price, and sell when it falls by 7.2% from a top. Long-only, this system returned 11.5% per year between 1969 and 2001, easily beating the market return of 7.9%. More advanced students of the market can consider substituting a multiple of the average true range (ATR) instead of percentage changes to define the strategy. The ATR indicator was designed to change with market volatility by measuring the absolute level of change within the market over a certain time. As an example of this approach, traders could use a filter of three times the 10-day ATR as the trigger for buy and sell signals. From a high or low, the ATR calculation would be completed and added or subtracted to identify the trade trigger. Using ATRs as the wave filter would have the benefit of accommodating market conditions, allowing a trader to stay with the trend longer during volatile times. Unfortunately, it can also increase the amount given back by traders during those volatile times. As such, this approach might be better suited for short-term, risk-tolerant traders. Conclusion No matter how it's applied, filtered waves are a valuable addition to an investor's toolbox. With them, traders are guaranteed to always be on the right side of the trend without being overrun by the crashing wave. With refinements, this versatile technique can be useful as part of a long-term trading strategy and can be applied to mutual funds, ETFs, or volatile stocks. by Michael Carr , investopedia.com Mike Carr, CMT, is a member of the Market Technicians Association and editor of the MTA's newsletter, Technically Speaking. He is a full-time trader and writer.

The Elliott Wave Principle

In the 1930s, Ralph Nelson Elliott, a corporate accountant by profession, studied price movements in the financial markets and observed that certain patterns repeat themselves. He offered proof of his discovery by making astonishingly accurate stock market forecasts. What appears random and unrelated, Elliott said, will actually trace out a recognizable pattern once you learn what to look for.

Elliott called his discovery "The Elliott Wave Principle," and its implications were huge. He had identified the common link that drives the trends in human affairs, from financial markets to fashion, from politics to popular culture. Robert Prechter, Jr., president of Elliott Wave International, resurrected the Wave Principle from near obscurity in 1976 when he discovered the complete body of R.N. Elliott's work in the New York Library. Robert Prechter, Jr. and A.J. Frost published Elliott Wave Principle in 1978. The book received enthusiastic reviews and became a Wall Street bestseller.

In Elliott Wave Principle, Prechter and Frost's forecast called for a roaring bull market in the 1980s, to be followed by a record bear market. Needless to say, knowledge of the Wave Principle among private and professional investors grew dramatically in the 1980s. When investors and traders first discover the Elliott Wave Principle, there are several reactions: • Disbelief – that markets are patterned and largely predictable by technical analysis alone • Joyous “irrational exuberance” – at having found a “crystal ball” to foretell the future • And finally the correct, and useful response – “Wow, here is a valuable new tool I should learn to use.” Just like any system or structure found in nature, the closer you look at wave patterns, the more structured complexity you see. It is structured, because nature’s patterns build on themselves, creating similar forms at progressively larger sizes.

You can see these fractal patterns in botany, geography, physiology, and the things humans create, like roads, residential subdivisions… and – as recent discoveries have confirmed – in market prices. Natural systems, including Elliott wave patterns in market charts, “grow” through time, and their forms are defined by interruptions to that growth. Here's what is meant by that. When your hands formed in the womb, they first looked like round paddles growing equally in all directions. Then, in the places between your fingers, cells ceased growing or died, and growth was directed to the five digits.

This structured progress and regress is essential to all forms of growth. That this “punctuated growth” appears in market data is only natural – as Robert Prechter, Jr., the world's foremost Elliott wave expert and president of Elliott Wave International, says, “Everything that thrives must have setbacks.” The first step in Elliott wave analysis is identifying patterns in market prices. At their core, wave patterns are simple; there are only two of them: “impulse waves,” and “corrective waves.” Impulse waves are composed of five sub-waves and move in the same direction as the trend of the next larger size (labeled as 1, 2, 3, 4, 5). Impulse waves are called so because they powerfully impel the market. A corrective wave follows, composed of three sub-waves, and it moves against the trend of the next larger size (labeled as a, b, c). Corrective waves accomplish only a partial retracement, or "correction," of the progress achieved by any preceding impulse wave.

As the figure to the right shows, one complete Elliott wave consists of eight waves and two phases: five-wave impulse phase, whose sub-waves are denoted by numbers, and the three-wave corrective phase, whose sub-waves are denoted by letters. What R.N. Elliott set out to describe using the Elliott Wave Principle was how the market actually behaves. There are a number of specific variations on the underlying theme, which Elliott meticulously described and illustrated. He also noted the important fact that each pattern has identifiable requirements as well as tendencies. From these observations, he was able to formulate numerous rules and guidelines for proper wave identification. A thorough knowledge of such details is necessary to understand what the markets can do, and at least as important, what it does not do. You have only just begun to learn the power and complexity of the Elliott Wave Principle. So, don't let your Elliott wave education end here. Join Elliott Wave International's free Club EWI .