The Shanghai Composite Index has taken a very hard hit over the last week, as the long-anticipated correction has taken hold. We have seen a 16% pullback in the Shanghai market over the last four trading days. That's a sharp whack even when you consider that the index was up over 50% on the year so far.

Shanghai Composite Index

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The breakdown in the Shanghai market shouldn't really be a surprise. We've seen a confluence of technical signals suggesting that the rally in that market was losing upside energy, and sentiment was certainly one-sided and bullish from local Chinese traders.

What is surprising is the fact that once the correction in Shanghai started, we didn't see a bearish reaction from the surrounding Asian markets, especially Hong Kong. In fact, these markets rallied in response to the weakness in mainland China.

Because shorting stock is not allowed in mainland China, traders have been shorting the Hang Seng aggressively in anticipation of a crash in Shanghai. The fact that the corrective action is unfolding in Shanghai and the Hang Seng is actually rallying may force shorts to cover and drive the Hang Seng higher.

The Shanghai index has been flashing several signals of an overextended market. We saw the index break out to the upside of the long-term uptrend channel. This type of "channel overthrow" suggests that traders have gotten carried away and moved the market into an exhaustive "blow-off" phase.

The index also formed a large momentum divergence, which shows a loss of upside energy and is a typical precursor condition of a breakdown when compared to the upside price action in the index over the last couple of months.

Traders sensed the "irrational exuberance" developing in the Chinese market and have been cautious with the surrounding Asian indices. The fact that the bubble in Shanghai has burst and the surrounding Asian markets have fared well may encourage buyers to come back in and bid these markets up.

We expect to see a much stronger reaction from the Hong Kong because of its status as a China proxy. The return of natural buyers and short covering on the index may break the Hang Seng out in the coming days and weeks.

Take a look at the

iShares China ETF

(FXI) - Get Report

as a potential long trade. This ETF is heavily weighted in Hang Seng-listed names. Wait for the dust to settle in Shanghai and then look to get long the FXI. A breakout over $116 would confirm the strength in this fund and suggest that the China trade is back on track.

At the time of publication, Scott Maragioglio had no positions in the stocks mentioned. Maragioglio had more than 15 years of technical analysis and money management experience before co-founding Epiphany Research. Epiphany Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indexes and sectors. He is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Mr. Maragioglio has also served on the board of directors of the AAPTA.