The Shanghai Composite Index made anew lownear 1,999 on September 26 and then developed a good rally rebound. There is a high probability the rally will continue after the Golden week holiday that ends Friday.
This development has the potential to establish the conditions for a trend reversal. This type of trend reversal is first shown with the Relative Strength Index (RSI) Divergence reversal signal.
RSI divergence occurs when the trend line using the valley lows on the RSI moves in the opposite direction to the trend line for the same time period applied to the valley lows on the Shanghai index . RSI divergence signals will appear first on the daily chart.
The first low in the RSI indicator appears at the same time as the index low near 2,040 shown as point A on the Shanghai index. Investors wait for the Shanghai index to make a new valley rebound low.
This situation creates two valley lows – point A and point B. At the moment we do not know where point B will be located so investors wait for this to develop.
The trend direction of these valley lows are compared with the trend line of the valley lows made at the same time on the RSI indicator. If these two trend lines show divergence then the RSI divergence pattern helps confirm the increasing probability of a trend change.
The RSI divergence is also confirmed with the classic test and retest pattern of trend reversal in a Guppy Multiple Moving Averages(GMMA) trend reversal signal.
The first rally is shown as point 1. The short term GMMA moved up and touched the lower edge of the long term GMMA before retreating. This is test 1.
The most recent rally is test 2. The short term GMMA penetrated into the long term GMMA shown at point 2 before retreating. Investors watch for these conditions in this trend reversal pattern.
A rebound rally is where the value of the short term GMMA moves up to the value of the upper edge of the long term GMMA and then retreats. This creates point 3 in the rally test, retreat and rally test pattern. The arrow shows the general nature of this type of development.
After the third rally investors wait for a retreat from the upper edge of the long term GMMA and wait for another new rally that will carry the value of the short term GMMA above the value of the upper edge of the long term GMMA. This creates classic GMMA trend breakout pattern behavior.
The most important development after the October holiday is the ability of the Shanghai index to develop a new rally rebound and complete the next step in the classic GMMA trend reversal pattern.
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.
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