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.
Now, the conditions that indicate a Hindenburg are only valid if both the ratio of new highs and lows are greater than 2.2%. In the example above, 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.
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.
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