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Correction coming for Chinese stocks, chart shows

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The Shanghai Composite Index has developed an astounding rally breakout in the past week, rallying more than 6 percent to hit levels not seen since December, and bringing gains to more than 10 percent from year-lows reached in March.

But, chart analysis shows this rally breakout may not be sustainable. Here's why.

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The breakout rally developed within the context of an up sloping triangle pattern. The triangle pattern is a long term bullish pattern developing over three months. The triangle pattern is created by the combination of the support resistance level near 2,060 and the up sloping trend line. This up sloping trend line starts from the low of 1,991 made on May 21. The second anchor point for the uptrend line is the open at 2,013 on June 20. The third anchor point of the uptrend line is the low of 2,018 on June 25. The fourth important anchor point is the low of 2033 on July 11.

The triangle pattern includes a base or vertical edge of the pattern created by 7 days of falling index activity starting from the high of 2,061 on May 13. The height of the base is measured and used to calculate the upside breakout target near 2,125. This target was rapidly achieved and exceeded.

The triangle pattern has developed inside the very wide trading band that extended from support near 1,980 to resistance near 2,160. A strong rally breakout similar to the breakout in February can reach the upper target level near 2,160. Again this has been achieved and exceeded.

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The upside target is calculated by measuring the width of the trading band and projecting this upwards above 2,060. This gives a long term target near 2,340. This was a support level July of 2011, and again in October that same year. It acted as a resistance level in both March and June of 2013. An extreme upside target is near 2,450.

The current index activity has not stabilized so it's not possible to suggest which of these targets is achievable and the time frame for these moves.

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Hence, these interpretations suggest the rally will retreat. While the upper edge of the long term trading band near 2,160 is the obvious support target, the rally has some of the characteristics of a parabolic trend. These trends collapse rapidly and typically retrace around 50 percent of the up move. This would mean a retreat to the area near 2,110, or down about 3.5 percent from current levels.

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.

  • Daryl Guppy is an independent technical analyst who appears frequently on CNBC Asia.

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