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The Dow and the shutdown – key triggers

Tuesday, 8 Oct 2013 | 3:43 AM ET
Paul Taggart | Bloomberg | Getty Images

If the United States defaults on its debt in the middle of October, just how far will the Dow Jones Industrial Average fall and would this provide a buying opportunity for October?

October has an undeservedly bad reputation in the market. While it's true that October has seen more than its fair share of market crashes and these overshadow the month's more positive side, markets usually close out the month higher. An October dip would be a buying opportunity; the debt ceiling brinkmanship may be the catalyst for such a buying opportunity.

(Read more: Could a shaky market get the debt ceiling raised?)

There are two key questions here: What degree of fall constitutes a buying opportunity, and what degree represents a major market reversal where it makes sense to go short and stay short? Chart analysis of the DJIA puts some figures on these critical levels.

The defining feature of the DJIA chart is the group of parallel trading bands. The most important of these is trend line A, which forms the middle core of the pattern. It is also the most well defined. This trend line starts in February 2011; it acted as resistance in July 2011, and again in April and September 2012 before the DJIA broke above it in February 2013.

The lower edge of the trading band is shown with trend line B. We can say that this started in December 2011 but it was really confirmed in June and November 2012. The width of this trading band is used to calculate the potential height of the resistance breakout in February 2013. Trend line C defines the upper limits of the breakout. This has not been an exact projection; the DJIA has hugged the value of trend line C, but it is a little lower than the target projection level. However, the behavior is intact.

(Read more: Debt ceiling? The dollar doesn't care)

Trend lines A and B provide a barometer of the market reaction to the budget and debt ceiling crises. A belief that these will be quickly resolved would see the DJIA pull back towards trend line A, which would serve as a support level. Current value for this pullback is around 14,660.

A prolonged crisis and a plunge into a short-term technical debt default has the potential to drive the DJIA down to the value of trend line B, currently near 13,250. This would be a major and significant correction; it would provide the type of deep rebound buying opportunity that October is famous for. A fall to this level would take the immediate upward momentum out of the market but it would not destroy the uptrend.

(Read more: Shutdown could give Q4 growth 50% haircut: Pro)

If the market moves below 13,250 we need to brace for a major market fall along the lines of 1987. This would be a fall with global consequences. Of course some people will go short near 15,000 and stay short for a fall below 13250. At this stage this is a matter of luck rather than judgment. For traders, the important features are the key trigger levels – 14,660 and 13,250.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders – www.guppytraders.com. He is a regular guest on CNBCAsia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.

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