The famous German airship known as the Hindenburg became one of history's most prevalent images of disaster when it burst into flames while making a landing in 1937. This airship now shares its name with a technical tool that was invented to help traders predict and avoid a potential stock market crash.
Thanks to a crafty mathematician named Jim Miekka, and his friend Kennedy Gammage, this technical indicator, known as the Hindenburg omen, can be used to predict sharp corrections, and can help traders profit from the decline or avoid realizing major losses before others ever see it coming.
In this article, you'll learn more about how this indicator is calculated and how its various signals can help you dodge the next market crash.
Tutorial: Market Breadth
The underlying concepts of the Hindenburg omen revolve around market breadth theories, mainly those developed by market greats such as Norman Fosback and Gerald Appel. This indicator is created by closely monitoring the number of issues on a given exchange, generally the NYSE, that have experienced fresh 52-week highs and new 52-week lows. By comparing these results to a standard set of criteria, traders attempt to gain insight into a potential decline in the broad market indexes. (For more on this indicator, read Market Breadth: A Directory Of Internal Indicators and Discovering The Absolute Breadth Index And The Ulcer Index.)
Market breadth theories suggest that when markets are trending upward, or creating new highs, the number of companies forming 52-week highs should exceed the number that are experiencing 52-week lows. Conversely, when the market is trending downward, or creating new lows, the number of companies trading at the lowest end of their 52-week ranges should drastically outnumber the companies creating new highs.
The Hindenburg omen uses the basic premises of market breadth by studying the number of advancing/declining issues, but gives the traditional interpretation a slight twist to suggest that the market is setting up for a large correction.
This indicator gives a warning signal when more than 2.2% of traded issues are creating new highs while a separate 2.2%, or more, are creating new lows. The disparity between new highs and lows suggests that the conviction of market participants is weakening, and that they are unsure of a security's future direction.
For example, assume that 156 of the approximately 3,394 traded issues (this number changes over time) on the NYSE reaches a new 52-week high today, while 86 experience new annual lows. Dividing the 156 new highs by 3,394 (total issues) will yield a result of 4.6%. Dividing 86 (new lows) by 3,394 (total issues) gives us a result of 2.53%. Because both of the results are greater than 2.2%, the criteria for the Hindenburg omen has been met and technical traders should be wary of a potential market crash. (For related reading, check out The Greatest Market Crashes and Panic Selling - Capitulation Or Crash?)
Note: The conditions that indicate a Hindenburg are only valid if both the number of new highs and lows are greater than 2.2%. If the number of new lows had been 70, rather than 86, then the criteria would not have been met because 70 divided by 3,394 is only 2.06%, which is below the required 2.2% that would indicate a Hindenburg omen.
Like most technical indicators, a signal should never be solely relied upon to generate transactions unless it is confirmed by other sources or indicators. The developers of the Hindenburg omen established several other criteria that must be met to confirm and reaffirm the traditional warning sign.
The first method of confirmation is to ensure that the 10-week moving average of the NYSE Composite Index is rising. This can easily be achieved by creating a weekly chart of the index, and overlaying a standard 10-period moving average. If the slope of the line is upward, then the second criterion for a potential correction is met. (To read about how to do this, see the Moving Averages tutorial.)
The third type of confirmation presents itself when the popular breadth indicator known as the McClellan oscillator has a negative value. This oscillator is created by taking a 19-day exponential moving average (EMA) and a 39-day exponential moving average of the difference between the number of advancing and declining issues. Once the two EMAs are calculated, they are subtracted from each other, and a negative reading is interpreted to mean that the number of new lows has been growing faster, recently, than it has in the past - a signal to traders that the bears are taking control and that a potential correction could be on the way.
Does it Work?
Every trader longs to be able to predict a stock market crash in order to profit from the decline or to protect some of their hard-earned profits. The Hindenburg omen is nearly as good as it gets when it comes to being able to identify these crashes before they happen.
According to Robert McHugh, CEO of Main Line Investors, "The omen has appeared before all of the stock market crashes, or panic events, of the past 21 years," speaking about 1985 to 2006. Having a signal that can generate sharp market declines is appealing to all active traders, but this signal is not as common as most traders would hope. According to McHugh, the omen only created a signal on 160 separate days, or 3.2% of the approximate 5,000 days that he studied.
Although this indicator does not provide frequent signals, it should be considered worthy to incorporate it into a trading strategy, because it could allow traders to dodge a major crash.
Technicians are always looking to hone the accuracy of a given signal, and the Hindenburg omen is no exception. Traders have added other confirming conditions, besides the ones listed above, in an attempt to reduce the number of false signals that are generated.
Most traders will require that the number of new highs not exceed twice the number of new lows when the signal is generated. By monitoring the advancing and declining issues, traders can ensure that the demand for a broad range of securities is not slanted in the bulls' favor. A lack of securities trading near the upper end of their 52-ranges is a representation of the deficient demand in the market, and can be used to reconfirm the prediction of a move downward.
The final piece of confirmation that traders will watch for is other transaction signals occurring in close proximity to the first. A cluster of Hindenburg omen signals, generally deemed to mean two or more signals generated within a 36-day period, is often interpreted to be much more significant than if only one signal appears by itself. All of the confirmation criteria that are mentioned in this article are suggestions of how to create a more accurate prediction of a market crash, but keep in mind that these can be forgotten if the trader would rather use the traditional methods.
There are several indicators based on the theories of market breadth, but few have been regarded in the same light as the Hindenburg omen because of its ability to predict a potential stock market crash. Many indicators and strategies have been invented for the purpose of trying to spot a major correction before it happens, but no indicator can predict these crashes with complete certainty - not even the Hindenburg omen. By using this tool, traders increase the probability of spotting a potential market crash before it occurs, and, as a result, may be able to profit from the decline or protect their hard earned profits from going up in smoke.