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| Diamonds |
Thursday August 07, 2008 |
Diamond
Technically speaking, a diamond pattern is a rally to a new high and
weakness to an intermediate support level, a second rally to a higher high and a
sharp decline through support, followed by a modest third rally and a decline
through longer-term trend
Why Does It Happen?
At first glance, a diamond pattern may look like little more
than head and shoulders top patterns with "crooked" necklines but this
only tells half of the story. In reality diamond patterns are more like
broadening top formations because they normally only reverse upward trends.
In this sense, they are always about distribution. The patterns begin when a very strong
stock with stellar growth trends moves to a new high and consolidates after a
lengthy advance. For several sessions the stock meanders in a narrow consolidation
as pundits discuss the longer-term fundamental merits of the stock but
eventually there is an upside breakout. In most cases, the cause of the
upside breakout will be an analyst "preview" of an upcoming earnings
report or positive comments from the company regarding new products or
clients. As the news breaks the stock surges to new highs on very
strong volume. In fact, the upside breakout usually proves legitimate
because the stock continues to move higher for several sessions. Then,
abruptly the stock begins to fall. Volume is light and there is no
corporate news to account for the weakness but as bullish investors rationalize
that the stock is merely correcting some of the recent gains, many investors
that bought the stock at lower prices are using the weakness to unwind long
positions. The stock continues to drift lower on relatively light volume until
there is a sector event that raises doubt about the most recent upside
breakout. Although all of the news from the stock in question has been
positive investors understand that the current share price carries a great deal
of risk because it has been priced for perfection. As selling continues
volume accelerates and when the stock falls through the previous upside breakout
level recent buyers panic leading to further weakness. Analysts continue
to reiterate "buy" recommendations but within days the share price is
devastated, moving far below even the most recent consolidation. As panic
subsides steps are taken by the company to reassure investors that all is still
well. Very often press releases are issued or leading Wall Street analysts
come to the defense of the stock, suggesting that it is a compelling value at
current levels. All of this leads to a reaction low and slowly the
stock begins to move higher. In the days ahead more positive corporate news is
disseminated, suddenly investors are reinvigorated and the share price
soars. Investors rationalize that the recent scare was a giant
overreaction and the stock offers great opportunity but as the rally progresses
volume is stubbornly average. Finally, the company releases more good news
and analysts pound the table with new buy recommendations but despite this the
stock does not come close to reaching the recent new high. To make matters
worse, on the day of the good news the stock opens higher but closes at or near
its low on heavy volume. The increase in volume and weaker stock price
suggests distribution, someone is selling into the good news. As the
stock price falls puzzled analysts and investors wonder how the stock could be
falling on such good news but investors that bought the stock at much lower
prices continue to use every rally to sell. Days later the stock breaks
sharply lower. Weeks later news is released suggesting that the fundamental
outlook has deteriorated.
How are Technical Targets Derived?
Because diamonds are very large patterns, the
technical implications are often extremely large. Technical targets are
derived by subtracting the difference between the record high and the reaction
low from the eventual breakout level. The breakout level will be determined by a
trend line drawn from the reaction low to the first significant low on the right
side of the pattern.
Diamond Reversal for ADC Telecom
In 2000 ADC Telecom (ADCT) stock rallied to $45.50 where it proceeded to
consolidate for several sessions. On July 20 the ADC received a three year
contract from German electronics conglomerate Siemens and the future seemed
bright. ADC rallied through $45.50 on huge volume and by July 27 the stock
had reached a record high at $49. That is when the selling began.
The following day Nortel (NT) announced that it would spend billions to purchase
Alteon Websystems. The aggressive nature of this transaction meant that
competitors would have to get bigger or perish. As investors fretted about
dilution, stock prices for the sector plummeted and ADC sank to a reaction low
of $33 on August 3. In the aftermath of the Alteon deal analysts once again
began to recommend telecom equipment stocks and it was not long before ADC was
moving sharply higher. On August 17 the ADC reported third quarter sales
rose a remarkable 67-percent and earnings beat estimates by 2-cents. On that
good news the stock spiked higher and briefly traded at $47.25 before closing
near the session low at $42.38. To make matters worse, competitor Visual
Networks (VNWK) tumbled 43-percent on August 23 after warning that sales would
be about half of what was expected due to a weakened spending environment.
Eight sessions later ADC traded as low as $34.38. On that day, August 29,
ADC company officials said they were comfortable with Wall Street estimates and
vowed not to make dilutive acquisitions. The stock rebounded smartly on a
NASDAQ-leading 39.68 million shares but the gains proved short lived -- and so
too was the corporate promise not make dilutive acquisitions. The stock
plummeted $31.31 on September 9 after announcing it would acquire money-
losing Broadband Access for $2.5 billion in stock. That announcement
marked the downside technical breakout for ADC. By late October of that year the
stock was changing hands at just $15.88.
Vital Signs
-
Diamonds are complex reversal patterns because
volume trends often suggest accumulation. Volume is heaviest at lows
and upside breakouts but moves to new and relative highs are always
characterized by one day reversals.
-
Although the spike to the reaction low may be
violent, the fact that stock holders are willing to surrender their stock at
drastically lower prices without substantive fundamental news portends lower
prices.
-
Diamonds are large patterns and the technical
implications are often dire. It is important to let the pattern reach
completion. This means establishing short positions only after the
downside breakout.
-
Downside breakouts often lead to small 2-3%
declines followed by an immediate test of the breakout level. If the
stock closes above this level (now resistance) for any reason the pattern
becomes invalid.
Diamonds are tough patterns because there are
many mixed signals. Our understanding of the diamond will definitely help
with the rounding top.
head
and shoulders top 
rounding top
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