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Chart: Hunting the Dow's dragon fly doji

Adam Jeffery | CNBC

You want evidence of the deleterious impact of high frequency trading and ETFs? Then look no further than the 1,000-point move on the Dow on Monday; that's 1,000 points down, followed by a rapid 1,000-point rise.

For several years I've noted the way this trading has fundamentally changed the operation of markets. Markets do not collapse without warning.

True, weaning the U.S. market off a diet of cheap money is proving more difficult than expected; this agonizing hike-no hike seesaw makes the earlier taper tantrum look like a storm in a tea cup. And the implied slowing in Chinese growth has highlighted the weakness in U.S. growth and its dependence in China for American prosperity.

But there are usually warning signals of a severe market downturn. In 2007 the Dow, the S&P 500 and the NASDAQ all developed end-of-uptrend patterns of behavior that technicians could read. That meant that the subsequent market fall was not a real surprise, although the degree of the fall was less expected.

Currently, though, the S&P 500 and the Nasdaq do not show any end-of-uptrend patterns. It is only the Dow that developed a end-of- trend pattern rounding top. The size of the rounding top was small and this usually suggests a limited fall, not the panic that has occurred recently. The S&P 500 and the NASDAQ also had panic selling but they were merely following the Dow.

The different behavior on the Dow and the other US indexes suggests the current retreat is driven by panicky sentiment, not a genuine trend change. The difference is important because a panic market must be traded differently to a trend change.

This is a panic stricken market with significant overreaction as shown by the rapid 1000 point move up and down in the Dow on August 24. This was created by high frequency algorithmic trading and shows the moves in the Dow is a panic reaction.

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Charting and technical analysis allow the trader to identify the conditions of the market collapse and set probable downside targets. Using this information the trader can decide if it's time to go short and to stay short for days or weeks. The trader can decide to wait for a consolidation and buy near support areas in anticipation of a rebound. So accurate analysis of support levels is important.

There is a high probability the market will develop consolidation near an a historical support level. In this panic-driven market there is a high probability the market will dip below support and then rebound to close near the support level. This creates a "dragon fly doji candlestick" on the daily chart. This chart pattern shows momentum exhaustion and is the signal to look for long-side trades.

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The weekly chart looks like a dragon fly doji pattern but this cannot be used to identify the end of the panic selling. The accurate and reliable dragon fly doji pattern must appear on the daily chart.

The rounding top pattern of the Dow has a downside target near 15,800. This is a little below the long-term uptrend line that has been in place since 2001, February. This is the middle of the long-term up-sloping trading channel for the Dow. Investors watch for a dragon fly doji dip below the 16,200 level with a test of the 15,800 target. The rebound following a dragon fly doji day is an entry signal for a continuation of the Dow uptrend and a rebound in the S&P and Nasdaq.

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