|For someone who views week to week changes of four percent or more as strong indication of price momentum, the recent, one-day 4% surge upward in the S&P 500 was an attention-grabber. It was also an excellent example of how important context can be.|
|The up-day of October 2, 2002 appears to trace out the second half of a diamond formation. The diamond formation can be both a continuation as well as a reversal pattern, and is formed by two sets of parallel trendlines--as shown in the chart of the S&P 500 presented here. Because prices can break from a diamond in either direction, it is usually advised to wait for prices to penetrate beyond one of the right-side trendlines before taking a position--long or short.|
|Figure 1: A diamond pattern emerges at the end of this downtrend in the S&P 500.|
|Graphic provided by: Prophet.net.|
|The size of the formation tends to determine the length of the breakout's initial move. The six-day diamond forming in the S&P 500 has a high of 860 and an intraday low of 800, providing for a formation size of 60 points. Adding this amount to an upside breakout point of about 840 gives an upside target of 900--setting up a test of the September highs (such as they were). A downside breakout point of 820, on the other hand, would suggest a downside target of 760, which would likely represent a test of the July lows.|
|There is an important caveat about diamonds. Diamond patterns are as prone to false breakouts as any number of other chart patterns. A look at the December Japanese yen futures contract is instructive in this regard. The December yen was breaking down from a triangle top (see my "Forex Triangle Tops," Traders.com Advantage, 9/10/02) when it began a sharp, flag-like counter move to the upside. After gapping down sharply against this trend (resuming the downtrend from the triangle top), December yen began moving up again.|
Figure 2: This diamond in December Japanese yen futures initially broke to the upside.
Graphic provided by TradeStation
This movement appears to have traced out a diamond pattern. December yen initially gapped up and out of the pattern in late September. But more recently, December yen has been moving back down. This combination of events suggests a false break to the upside, with a resumption of the down trend following shortly thereafter. Thus, one rule of thumb with diamonds--that the top and bottom of the formation tend to represent resistance and support, respectively, can be helpful in assessing the necessary follow-through any breakout requires in order to become a trend.
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