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Next Few Weeks Crucial to Plot Shanghai's Direction

The Shanghai Composite Index's recent breakout above the 2480 resistance level has been very strong, and there is high likelihood the uptrend will continue. However, it must be said that the index's chart shows a confused pattern and this makes it difficult to project current activity and set target levels.

The long-term breakout pattern is created by the fan trend line reversal. The position of fan trend line A, B and C are clear. We can also add fan trend line D but the evidence for this trend line is not strong. The fan trend line pattern is useful for identifying the developing breakout conditions, but it is not useful for understanding how the trend breakout will develop.

The index also shows the development of a weak inverted head-and-shoulder pattern. The pattern is weak for two reasons. Firstly, the left shoulder was created May 21 with the low at 2481. Then the market drifted sideways for another 5 weeks so the shoulder is not well defined. The head of the pattern is created on July 2 with the low near 2319.

Secondly, the right shoulder was created with the fast moving retreat starting July 15 and the rebound from the low at 2389 on July 16. Normally the right shoulder takes longer to develop, and is normally a very clear retreat and rebound pattern that develops over 5 to 15 days. The fast development of the right shoulder is a signal for caution and suggests a weak inverted head and shoulder pattern. This means the trend reversal targets are also treated with caution.

Using the inverted head and shoulder pattern analysis the position for the neckline of the pattern starts with the high on May 28 and is followed the rally peaks around June 24. The distance between the head of the pattern and the neck line is 195 index points. When this value is projected upwards it gives an upside target near 2730. The weak inverted head and shoulder pattern means this target, again, should be treated with caution, especially considering it's not near to any historical support and resistance level.

The strong historical support and resistance level is near 2680, which is likely the minimum target for the current market rally. The maximum target is near 2730.

The normal development for a long term trend breakout includes a pattern of rally, retreat, rally and retreat. The current Shanghai Index rally is the first test of the strength of the downtrend. A retreat will develop, possibly from near 2680. Strong historical support is located near 2580 so traders will look for a rebound from this support level. This level is near the upper edge of the long term GMMA.

The Shanghai index has several confused chart patterns, but the chart patterns all deliver the same message. The breakout from the downtrend is sustainable and it has a higher probability of developing into a long term uptrend. The exact nature of the new uptrend will be decided in the next few weeks.

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 CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.

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