Since the market began anticipating that Chairman Bernanke and the Federal Reserve would ease up on the gas pedal propping up the U.S. economy, stocks appear to have become more volatile. This may create the potential for stocks to move sharply in either direction.
In this type of environment, traders may be able to look for diamonds in the rough—that is, stocks exhibiting technical patterns known as diamonds, which can help forecast the direction a stock might move.
What is the diamond pattern?
A diamond is a classic technical pattern that typically forms over several months. The pattern can be identified by its diamond-like shape, which forms from straight boundary lines that may be drawn on the price action of a security (see the chart below).
“Diamond patterns essentially represent equilibrium between buyers and sellers,” says David Keller, CMT, managing director of technical research at Fidelity and president of the Market Technicians Association. “The first half of the diamond is a broadening pattern with higher highs and lower lows, and the second half of the diamond pattern is a symmetrical triangle with lower highs and higher lows,” Keller points out. “So, even though the stock may have undergone a period of increasing and then decreasing volatility, it has essentially gone nowhere by the end of the diamond pattern.”
Diamonds can be both bullish and bearish. A diamond bottom is a bullish pattern that is interpreted as a reversal of a downtrend. It can be identified when a security makes higher highs and lower lows in a broadening formation near the end of a downtrend. As the broadening formation unfolds, the trading range may narrow and then form a symmetrical triangle to complete the diamond pattern. Conversely, a diamond top is a bearish pattern that is interpreted as a reversal of an uptrend that may form after a lengthy advance.
In addition to diamond tops and bottoms, a diamond may also be a continuation pattern whose formation marks the resumption of a previous trend. That is, if a diamond were to form during a downtrend (or uptrend) and after the pattern is complete the stock were to continue to move lower (or higher), the diamond might be interpreted as a continuation pattern.
However, the more common use of the diamond pattern is as a reversal signal. Traders may want to wait for confirmation to see if the price actually does reverse after the completion of the diamond pattern.
Diamonds are forever
Identifying the diamond pattern can sometimes be complex, particularly in choppy markets when stocks may signal unreliable patterns by moving quickly, and sometimes sporadically, in either direction. To simplify the analysis, Fidelity makes available a preset expert screen provided by Recognia called “Diamonds Are Forever-Bullish,” which identifies when specific stocks exhibit this classic technical pattern. (Note that you are required to log on to Fidelity.com to access this preset strategy.)
The screen filters for common stocks that have completed a diamond bottom or bottom triangle over the past 6 to 39 weeks, that also fall within the lowest 60% PEG ratio, have a 90-day average volume greater than 50,000 shares, and whose price performance is in the highest 60% on the day of the screen. The graphic below illustrates the Diamonds Are Forever-Bullish preset screen as of July 16, 2013.
Based on this screen from July 16, 2013, AT&T (T), Adtran (ADTN), Volterra Semiconductor (VLTR), Homeaway (AWAY), and Liveperson (LPSN) were the top five stocks that fit the criteria. Narrowing this screen to exclude bottom triangles and focus only on diamond bottoms, the top five stocks in the screen are AT&T (T), Homeaway (AWAY), Vantiv (VNTV), Consolidated Edison (ED), and Intel (INTC).
With the market near all-time highs, it is also possible to look for uptrending stocks that are forming continuation diamond patterns (i.e., bullish stocks that could continue to move higher). Adjusting for this filter, the top five stocks that fit the criteria are EQT Corp (EQT), Owens and Minor (OMI), Baxter International (BAX), Mylan (MYL), and Markwest Energy Partners (MWE).
How can you trade diamond patterns identified by the screen? “The trigger for a diamond pattern is a breakout through either the upper or lower boundary of the pattern,” Keller points out. Of course, everything hinges on what the broad market is doing. “If we see another leg higher in a cyclical bull market, stocks breaking out of continuation diamond patterns could be ideal buy candidates,” he says.