Myths about Chartism (Part 1): Diamond FormationsCurrently, the ideas of the fathers of Technical Analysis are outdated in the face of the flood of trendy popularizers. Concepts that once formed the foundation of the profession have been manipulated, and with them, centuries of experience have been diluted in the eagerness for novelty and total disinterest in the past (the main advantage of the investor).
Beyond "sticker collectors," a chartist was someone who studied the psychology of the masses and their indelible mark on the markets. Above all, they were logical beings (something suspiciously frowned upon nowadays). Behind every fluctuation or manifestation of price action, a chartist tried to achieve a full understanding, and it was Richard W. Schabacker who was the first investor to compile and publish decades of study in 1932, in the book titled "Technical Analysis and Stock Market Profits: A Course in Forecasting."
Relying mostly on this first and purest source of information, and with the belief that mass psychology has not changed, I plan to write a series of well-documented articles on Chartism, the backbone of Technical Analysis in the West.
Diamond Formation
Ideas from Richard W. Schabacker:
"This pattern could be considered a variant of the Head and Shoulders formation. However, it could more accurately be described as a formation composed of two base Triangles with their vertices pointing in opposite directions – an Inverted Symmetrical Triangle merging into a normal Symmetrical Triangle."
"Rarely is it found in a perfectly symmetrical and clearly defined form; some degree of leeway must be taken and is permissible when tracing its boundaries. However, when it appears, it is a reliable formation and one that allows the trader to take a profitable position. It is more often found at tops than at bottoms."
"Head and Shoulders formations with declining necklines generally offer few opportunities for taking profitable trading positions, but when they also allow for the construction of a Diamond, they provide a good breakout signal at a much higher and more profitable level."
"It appears at bottoms as well as at tops, and is equally reliable as a reversal signal in either position."
Content Analysis:
I want you to pay special attention to how these formations are described as reliable r eversal signals . Unlike what is currently popularized, for Schabacker, a diamond formation is a corrective pattern, provided it forms at the top or bottom of a trend (with a greater presence at the top). The theory that a diamond formation can be either corrective or a continuation pattern, I have researched, goes back to the work of John Magee (and Edwards ), a disciple of Schabacker. Magee, in his influential book "Technical Analysis of Stock Trends" (1948), graphically shows an example where a "diamond formation" ends up generating a continuation of the trend. The issue is that the case presented by Magee, rather than a trend, is a strong and extremely vertical explosion of bullish volatility. By applying technical lines to the (natural) reversal, Magee believes he sees a diamond formation, a mistake that would not have been passed down to future generations of investors had he applied the logic of this type of corrective patterns.
Logic Behind Diamond Formations:
Imagine an uptrend that cannot surpass the previous high and experiences a deeper-than-normal pullback (both signs of weakness); then, subsequent bullish attempts are thwarted by selling forces. As supply and demand compress, we will find exhausted and demoralized buyers, alongside confident sellers. At some point, many of those demoralized buyers might panic (with good reason) and switch sides to join the selling forces. Another no less crucial detail is that each rejection by the sellers will create walls of liquidity that are difficult for the exhausted buyers to overcome; meanwhile, downward the path will be clear, which will attract more sellers, enticed by the excellent risk-reward ratio and the strategic placement of SLs (close and extremely protected). In such a scenario, a sharp price drop is logical and highly probable.
"A process of consolidation involves many trapped participants and increasingly tight SLs, so liquidations will generate strong bursts of volatility."
In a downtrend, it would be exactly the opposite. If the selling force cannot break below the previous low and rebounds with extreme strength, these are signs of weakness. Then, if buyers reject each selling attack until supply and demand are compressed, the most likely scenario would be an upward explosion. Demoralized and fearful sellers, worried about a probable liquidation, will not take long to capitulate their positions to increasingly strong and confident buyers. The influx of new demand, attracted by an excellent risk-reward ratio and a relatively close, well-protected SL, will likely precipitate things upward with high probability.
Additional Notes:
-In the BTCUSDT chart, you can see with lines where John Magee would take profits (TP), but I recommend that profit-taking be done horizontally aligned with the base of the diamond (Richard W. Schabacker did not specify details about taking profits in this type of formation).
Richard W. Schabacker and John Magee (and Edwards) considered volume important when validating the breakout of the formation, but I recommend validating the breakout by understanding the logic and context in which the formation occurs (moreover, waiting for a breakout with volume might cause you to miss more than half of the move, as price compressions generate strong bursts of volatility).
-It's natural that John Magee's and Edwards' misinterpretation impacted several generations of technical analysts, as "Technical Analysis of Stock Trends" (1948) is one of the most influential works in the field ( "The bible of technical analysis"). It was published after World War II, at a time of financial market expansion and growing interest in investment tools. Schabacker, on the other hand, died young (1938).
-The introduction to "Technical Analysis of Stock Trends" (1948) and statements on the book's cover reveal the debt that Magee and Edwards feel towards Mr. Schabacker. Their frankness and honesty should be admired because they freely declare that they did not develop or create the many facets of Technical Analysis they were passing on to a new generation.
