Last Updated on 17 November, 2020 by Samuelsson
Stock market crashes can wipe out traders’ and investor’s profits or even put them at a huge loss in no time. If you have been in the market long enough, you will know that stock market downturns always happen faster than the preceding or succeeding bull markets — what took the market many years to build can be wiped out in one month. As a result, traders are always looking for ways to anticipate a market downturn before it happens, and the Hindenburg Omen indicator seems to be the answer.
Widely used by financial analysts, traders, and investors alike, the indicator provides a forewarning of a market decline. Those who make use of it may be able to protect their positions before the downturn happens or even position themselves to profit from the downturn.
In this post, you will learn the following:
- What the Hindenburg Omen is
- How it is calculated
- How it works
- How to use it in your trading
- The main criticisms of the indicator
- Ways to improve the signals
What is the Hindenburg Omen?
The Hindenburg Omen indicator is a technical tool that tries to predict an increased likelihood of a stock market crash by comparing the percentage of stocks making new 52-week highs and new 52-week lows to a predetermined reference percentage.
Named after Germany’s Hindenburg airship that crashed in 1937, the indicator was created by James R. Miekka but named “the Hindenburg Omen” by Kennedy Gammage of the Richland Report. While this indicator may have a funny name, it is a very serious and useful technical tool that has a good track record.
Hindenburg Omen is designed to anticipate a bearish event in the stock market. When it is triggered, the indicator warns about an imminent sharp correction or a full-blown bear market within the next 30 days, so traders can close their positions to avoid realizing major losses, stay away from the market, or position themselves to profit from the decline.
The indicator tells you when there is an increased probability of a stock market crash. It compares the percentage of new 52-week highs and lows to a predetermined reference percentage to predict the likelihood of a downturn in the stock market. But the indicator is not used alone; it has to be confirmed with other indicators that tell the direction of the market and the likelihood of increased declining stocks. For example, during the 30-day period after the Hindenburg Omen is triggered, the McClellan Oscillator (MCO) has to be negative to confirm the bearish signal, but if the MCO remains positive, the signal is rejected.
So the indicator is not only based on market breadth theories but also on the signs of bearish tendencies in the market. In addition, the market must already be in an established uptrend for the Hindenburg Omen signal to be valid. In other words, a market crash can only be anticipated in a bull market.
How to calculate the Hindenburg Omen
The idea behind the indicator is based on the concept of market breadth divergence, which simply means that while the overall market (an exchange’s composite index) is trending in one direction, not all stocks are participating in that move. Some are making new highs, while many are also making new lows, creating a state of confusion.
There is no specific formula or calculation for the Hindenburg Omen. However, there are criteria that must be met for a Hindenburg Omen signal to be valid, and they are as follows:
- An ongoing bull market: The broad stock market index, such as the S&P 500 Index, or the composite index of the stock exchange, such as the NYSE Composite Index, should still be in an uptrend. This is verified with a 10-week moving average or a 50-day moving average that is sloping upward.
- New highs plus new lows: There is a market breadth split as the daily number of stocks making new 52-week highs and 52-week lows from among the components of the stock market index are greater than a threshold amount. Usually, 2.2 percent is used as the reference value, but some analysts may use 2.8%.
- Signs of bull weakness: Despite the overall uptrend, the bulls are not quite dominating across the entire market breadth; there are signs of bull weakness. The number of stocks making 52-week highs must not be more than two times the number making 52-week lows for the signal to be valid.
- Signs of an increasing bearish momentum: Finally, the bears must be showing signs of resurgence, as evidenced by a negative value of the McClellan Oscillator (MCO).
Understanding how the Hindenburg Omen works
As we stated earlier, the underlying concepts of the Hindenburg Omen are based on the market breadth theories developed by Norman Fosback and Gerald Appel. Market breadth theories suggest that when markets are trending upward, or creating new highs, the number of companies forming 52-week highs should be far more than the number that are experiencing 52-week lows. On the other hand, 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.
Hindenburg Omen works the basis of this market breadth, but it focuses on situations where the overall market trend is upward. The indicator closely monitors the number of stocks on a given stock exchange, typically the NYSE, that are recording new 52-week highs and new 52-week lows and compares these results to a standard set of criteria to show when there is a divergence in the market breadth — a situation where an ongoing bullish doesn’t cut across the entire market breadth as an increasing number of stocks are making new lows too.
The indicator gives a warning signal when greater than 2.2% of the listed stocks on the exchange are making new highs while another 2.2% (or more) are making new lows. That level of new highs and lows suggests that there is no consensus in the market since the ongoing bullish trend is not felt across the market breadth. To put it simply, the market participants are unsure of the market’s future direction.
For instance, let’s say that 160 stocks out of about 3,400 stocks (the actual number changes from time to time) on the NYSE recorded a new 52-week high today while 100 stocks recorded new 52-week lows. Dividing the values with the total number of listed stocks (3400) shows that 4.7% recorded a new high, while 2.9% recorded a new low. Since both of the results are greater than 2.2%, the basic criteria for the Hindenburg Omen have been met, and there is a warning of a market breadth split.
But like we stated earlier, the Hindenburg Omen signal has to occur in a specific setting for the signal to be valid. The creators of the Hindenburg Omen proposed several other criteria that must be met to confirm the warning signal. The first one is to confirm that the market is in an uptrend. You can do this by placing a 10-week moving average on the chart of the NYSE Composite Index and checking the direction of its slope — it must be sloping upward.
The second confirmation is that the number of stocks making new yearly highs must never be more than twice the number of stocks making new lows. In our example above, 160 is less than 200 (2×100). Finally, the third confirmation is that the popular breadth indicator, known as the McClellan oscillator, must have a negative value. This oscillator consists of a 19-day EMA and a 39-day EMA of the difference between the number of advancing and declining stocks. After calculating the two EMAs, subtract the 39-day EMA from the 19-day EMA: a negative reading is interpreted to mean that the number of new lows has been growing faster, in recent times, than it has in the past. An easier way to confirm a negative reading is when the 39-day EMA is below the 19-day EMA. Whichever way you read it, a negative signal implies that bears are taking control and a potential correction or a full bear market could be on the way.
How to use the Hindenburg Omen in your trading
There are different ways to make use of the Hindenburg Omen indicator in trading. It all depends on your style of participating in the market (investing or swing trading) and your trading situation when the Hindenburg warning signal appears. Let’s take a look at some of the basic actions traders take when this signal occurs:
Exit the market
Traders and investors who already have positions in the market may see the Hindenburg Omen signal as a warning sign to close their positions and secure whatever profits they have made at that point. Not getting out of the market may result in giving back all their profits and even ending up with a loss.
Some investors, especially the big investors, may decide not to close their positions outright but, instead, buy protective puts that would allow them an easy way out if the market crash eventually happens as predicted. A protective put allows the buyer to sell his stocks to the writer at an agreed strike price within a specified timeframe.
Delay trade entry
Investors and traders, who don’t already have a position in the market but are planning to make some trades may decide to hold on for some time to know the situation of the market before making any trading decisions.
This way, they prevent a scenario where they enter the market at the very top, just before a market crash — a situation that would have resulted in an inevitable loss. Staying away from the market allows them to preserve their capital for a better time.
Go short on the market
Some experienced traders who operate a margins account may see the Hindenburg Omen signal as a time to look for shorting opportunities in the market, considering the impending market downturn. They take short positions in the market so as to profit from the market decline.
This type of traders already have strategies they use to make their short trades, so they normally combine them with the Hindenburg Omen signal to get high probability trades.
Criticisms of the Hindenburg Omen
Many financial analysts are skeptical about the Hindenburg Omen indicator. In fact, whenever the indicator’s warning signal is triggered, you will see a bunch of analysts giving different reasons to ignore the signal. Some of their concerns are legitimate, and they include the following:
- False signals: While Hindenburg Omen has always given a signal before every major market crash in the past 35 years or more, there are many times it gives a signal without any market crash occurring.
- Small-cap stocks and non-stock issues: Skeptics also argue that the indicator can be skewed by small-cap stocks and non-stock exchange-traded funds.
- The effects of international stocks: Some traders are concerned that this indicator may be skewed by exchange-traded securities that track international stocks, which are now prevalent on U.S. stock exchanges. If all the securities (both stocks and non-stocks) listed on the NYSE or NASDAQ are used in generating the Hindenburg Omen signal, the conditions of certain foreign stocks on foreign soil can affect what the indicator says about the U.S. stock market. For example, if the ETFs tracking foreign stocks are making new lows while U.S. stocks are making new highs, the indicator might give a false warning the U.S stock market is about to experience a crash when the market itself is in good condition.
A way to improve the Hindenburg Omen signal
Technical analysts and traders are always looking for ways to improve the accuracy of any given signal, and the Hindenburg Omen is no exception. In an attempt to reduce the number of false signals that are generated, traders have to use a cluster of signals over a specified timeframe rather than just one signal.
A cluster of Hindenburg Omen signals is generally deemed to mean two or more signals generated within a 30-day period. It is usually believed to be much more significant than if only one signal appears. The more signals that appear within the timeframe, the higher the likelihood of a market decline.