Be Aware Of The Hindenburg

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/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.

The Basics
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.

Indicator
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.

Confirmation
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 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 profit. 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.

Further Accuracy
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.

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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.

Conclusion
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.
By Casey Murphy,
Access Investopedia's Forex Advisor FREE Report - The 5 Things That Move The Currency Market

Tales From The Trenches: Hindsight Is 20/20

When it comes to the financial markets, most traders don't hesitate to discuss the trades they've used to turn a handsome profit. But, have you ever noticed that they never seem to talk about their losing positions or the trades that didn't turn out as well as they'd hoped?

Trading is an endeavor that will eventually result in a losing position. So did you learn anything from the trade, or did you try to erase it from memory as soon as it was over?

Taking an occasional loss isn't something to be ashamed of. In fact, it should be seen as a learning experience. And although traders may want to spare their egos and avoid sharing their bad trading experiences with others, at ChartAdvisor.com, we feel that these trades can be just as valuable as the winning ones. Read on to find out how swallowing your pride and examining your worst mistakes can help you prevent them from happening again. (To learn the basics to technical analysis, see our Technical Analysis, Analyzing Chart Patterns and Exploring Oscillators and Indicators tutorials.)

The Pattern
On January 30, 2006, ChartAdvisor.com identified a potential ascending triangle forming on the chart of Global Crossing Inc. (GLBC). This ascending triangle pattern, as illustrated in Figure 1, illustrates how the pattern develops in an ideal situation.

Source: MetaStock

Figure 1

Notice how the first trendline is drawn horizontally at a level that has prevented the price from moving higher on several occasions. The second trendline is drawn so that it connects a series of increasing troughs, which is often thought to represent an increase in demand. It may take the buyers a few tries to push the price past the upper resistance level, but once a breakout does occur, the buyers aggressively send the price of the asset higher. (To learn more, read Continuation Patterns - Part 1 and Triangles: A Short Study In Continuation Patterns.)

The Losing Trade
The ascending triangle pattern we identified in GLBC's chart is a signal of a possible break toward our short-term target of $20.41. The thesis behind this trade setup is that a large number of traders would enter orders to buy GLBC once the price was able to surpass the resistance of $18.06 - a level that had prevented the bulls from pushing the price higher several times over the past few months.

Source: MetaStock

Figure 2

Like all traders who use the ascending triangle chart pattern, we were expecting to see the price of our identified stock violently make a move toward our target, which is when we would sell the stock and realize a quick and handsome profit of 13%. Ascending triangles are many traders' favorite pattern because it is not uncommon to see a stock hit a target price set 10-20% away from the entry only days after the breakout.

As you can see in Figure 3, the much anticipated move above the entry price came on March 1, 2006. To our dismay, it was not a sharp move higher as we had hoped. Actually, the breakout represented a worst-case scenario - the bears quickly responded to the move and pushed the price back below the entry later in the day.

The Response
This is where the story turns to one of risk management. At ChartAdvisor.com,we attempt to cut our losses at a standard 3% below the entry price. This ensures that if the move above the entry is indeed a failed breakout, we will be out of the position before the other bulls decide to follow suit and push the price of the asset substantially lower, resulting in much bigger losses.

Source: MetaStock

Figure 3

In this specific trade, our strict risk management strategy took us out of our position on the exact same day that we had entered it, resulting in a small 3% loss. At ChartAdvisor.com we adhere to the theory of letting profits run while quickly cutting off a losing trade before it can cripple our returns. However, although this strategy prevents devastating losses, it can also cause traders to miss out on substantial gains if the investment thesis proves to be correct at a slightly later date. This is exactly what happened in the GLBC trade. Should we have carried out this trade any differently?

The Aftermath
The frustration of having a trade go against you after you've watched it develop for days, weeks or even months can be agonizing, but sometimes this feeling can get worse when you see what happens after you've exited your position or taken the pattern off your radar. In our example, the move higher that we were expecting came twelve trading days after we were taken out of our position.

Source: MetaStock

Figure 4

Clearly, we missed the boat on GLBC, but this missed opportunity is not a worst-case scenario - we know that this trade could easily have gone the other way, resulting in a major loss.

As you can see from a different ChartAdvisor.com recommendation, West Marine Inc. (WMAR) in Figure 5, a tight exit stop loss strategy has its purpose. In this case, we managed to avoid holding onto a position that continued to move lower after we chose to exit. We continued to stick to our strategy so that we could attempt to eliminate the chance of holding a stock like WMAR through large declines, while also giving us exposure to sharp breakouts like the one seen on GLBC. We may not catch them all, but over time we are confident that we'll catch our fair share of these profitable moves and have a strategy that will outperform many others.

Source: MetaStock

Figure 5

A Lesson Learned
Looking back with hostility on trades that did not turn out as expected is a normal reaction, but failed trades can provide critically important lessons for traders. Traders must learn to stick to their strategies and be willing to examine trades like GLBC. Only then can they discover whether an underlying thesis regarding a particular trade was correct. In the case of GLBC, the chart pattern did correctly predict a sharp move higher. Often you will find that little more than bad timing and an unlucky set of circumstances stands in the way of a very nice profit, vindicating your continued resolve to sticking to your strategy.

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So should we have held on to the GLBC trade? Not a chance!

Conclusion
Unlucky trades happen to every trader regardless of experience; the only difference is that the best traders brush off short-term losses and missed opportunities without dwelling on them and realizing that it is how they react to future setups that will determine their success in the trading game over the long run. At ChartAdvisor.com, we believe that by using chart patterns such as the ascending triangle, traders can put the probability of capturing extreme short-term moves on their side without taking on too much risk. Not all trades will work out as planned, but traders will still be able to make impressive returns, particularly if they are able to learn from past mistakes.

To read more of ChartAdvisor.com's trader mistakes and glories, see Tales From The Trenches: Don't Count On Luck.

By Casey Murphy,
Access Investopedia's Forex Advisor FREE Report - The 5 Things That Move The Currency Market

Casey Murphy is the senior analyst at ChartAdvisor.com. He contributes educational articles to Investopedia.com and is a graduate of the University of Alberta School of Business. ChartAdvisor is an independent technical analysis service dedicated to uncovering explosive short-term trading opportunities for individual investors. To learn more about how you can start a free trial and put Casey's insightful analysis and expert pattern recognition to work for you, click here now.

A Look At Kagi Charts

The task of figuring out the short-term direction of any financial asset can seem daunting, especially when traders try looking at the chart of the asset's price for guidance. Looking at the day-to-day price fluctuations seen on a chart can seem choppy and can make it extremely difficult to determine which price movements are important and will significantly affect the direction of the security.

Luckily for traders, several charting techniques have been developed, which attempt to filter out random noise and concentrate on the important moves that act as drivers of an asset's trend. One method of filtering out this noise, which is also the focus of this article, is known as the kagi chart. (For more insight, see Trading Without Noise and Dragons, Samurai Warriors And Sushi On Wall Street.)

Kagi Chart Construction
Kagi charts consist of a series of vertical lines that depend on price action, rather than on time like the common charts such as line, bar or candlestick. As you can see from the chart below, the first thing that traders will notice is that the lines on a kagi chart vary in thickness depending on what the price of the asset is doing. Sometimes the lines are thin, while at other times the lines will be thick and bolded. The varying thickness of the lines and their direction is the most important aspect of a kagi chart because this is what traders use to generate transaction signals. (For related reading, see Analyzing Chart Patterns.)

Figure 1

Kagis and Candlesticks
The different lines on a kagi chart may seem overwhelming at first glance so let's walk through an example of Apple Computer Inc. (AAPL) between May 8 and December 1, 2006. We believe that this example will make it much easier to fully understand how this interesting type of chart is created. We've also attached a regular candlestick chart to several of the kagi charts to illustrate what the price of the underlying asset has done to cause a certain change to the kagi chart.

As you can see in Figure 2, the price of AAPL shares started to decline shortly after the start date of our chart. As the price fell, a vertical line was created, and the bottom of this vertical line was equal to the lowest closing price. If the next period's close were to be lower than the current bottom on the line, then the line would be extended to equal the new low. The line will not change directions until the price moves above the bottom of the kagi line by more than a preset reversal amount, which is usually set at 4%, although this parameter can change depending on the security or trader's preference.

Figure 2

The Reversal
On June 1, 2006, AAPL shares closed above the kagi low by 4.02% - more than the 4% reversal amount needed to change the direction of the chart (4%). As you can see from the chart below, the reversal is shown by a small horizontal line to the right followed by a vertical line in the direction of the reversal. The rising Kagi line will remain in the upward direction until it falls below the high by more than 4%.

Figure 3

The reversal was welcomed by many traders because this was the first bullish kagi signal that was generated since the chart was created in early May. However, unfortunately for the bulls, the move was unsustainable as the bears responded and pushed the price below the high of the Kagi line by more than the reversal amount of 4%. The downward reversal is shown on the chart as another horizontal line to the right followed by a line moving in the downward direction.

As you can see from Figure 4 below, the bulls and bears spent the following few weeks fighting over the direction of Apple shares, causing the kagi chart to reverse directions several times. Three of the moves higher that occurred between June and July were greater than 4% above the chart's low, which caused the kagi chart to reverse directions. These moves represented an increasingly bullish sentiment, but they were not strong enough to fully reverse the trend. (To learn more, read Retracement Or Reversal: Know The Difference and Support And Resistance Reversals.)

Figure 4

The Thick Line
The number of false reversals started to show traders that bullish interest in the stock was increasing, but that the true trend remained in the bears' control. This story changed on July 20, 2006, because of a gap that was substantially greater than the 4% needed to reverse the chart's direction. In fact, the gain was large enough to send the price above the previous high drawn on the kagi chart, shown by the most recent horizontal line drawn near $57.40. A move above a previous Kagi high like the one shown in the figure below causes the line of the kagi chart to become bold.

Figure 5

A shift from a thin line to a bolded line, or vice versa, is used by traders to generate transaction signals. Buy signals are generated when the kagi line rises above the previous high, turning from thin to thick. Sell signals are generated when the kagi line falls below the previous low and the line turns from thick to thin. As you can see in Figure 6, the Kagi chart reversed directions after the sharp run up, but a simple reversal does not change the thickness of the line or create a transaction signal. In this example, the bears were unable to send the price below the previous low on the kagi chart.

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When the bullish momentum continued again in mid August, the price shifted back in the upward direction, creating a new swing low that will be used to create future sell signals. Ultimately, the bulls were unable to push the price of Apple shares back below the low, causing the kagi chart to remain in a bullish state for the remainder of the tested period. The lack of a sell signal enabled traders to benefit from the strong uptrend without being taken out by random price fluctuations.

Figure 6

Longer-Term Example
Now that we have an understanding of what generates a transaction signal when using a Kagi chart, let's take a look at a longer-term example using the chart of Apple Computer (April 30, 2005 - December 31, 2006). Notice how a move above a previous high causes the line to become bold, while a move below a low causes the line to become thin again. The changing thickness is the key to determining transaction signals as this fluctuation illustrates whether the bulls or bears are in control of the momentum. Remember that a change from thin to thick is used by traders as a buy sign, while a change from thick to thin shows that downward momentum is prevailing and that it may be a good time to consider selling.

Figure 7

Conclusion
Day-to-day price fluctuations can make it extremely difficult for traders in the financial markets to determine the true trend of an asset. Luckily for traders, methods such as kagi charting have helped put an end to focusing on unimportant price moves that do not affect future momentum. At first, a kagi chart can seem like a series of randomly placed lines, but in reality, the movement of each line depends on the price and can be used to generate very profitable trading signals. This charting technique is relatively unknown to mainstream active traders, but given its ability to identify the true trend of an asset, it wouldn't be surprising to see a surge in the number of traders that rely on this chart when making their decisions in the marketplace.

By Casey Murphy,
Access Investopedia's Forex Advisor FREE Report - The 5 Things That Move The Currency Market

Casey Murphy is the senior analyst at ChartAdvisor.com. He contributes educational articles to Investopedia.com and is a graduate of the University of Alberta School of Business. ChartAdvisor is an independent technical analysis service dedicated to uncovering explosive short-term trading opportunities for individual investors. To learn more about how you can start a free trial and put Casey's insightful analysis and expert pattern recognition to work for you, click here now.

Support & Resistance Basics

The concepts of support and resistance are undoubtedly two of the most highly discussed attributes of technical analysis and they are often regarded as a subject that is complex by those who are just learning to trade. This article will attempt to clarify the complexity surrounding these concepts by focusing on the basics of what traders need to know. You'll learn that these terms are used by traders to refer to price levels on charts that tend to act as barriers from preventing the price of an asset from getting pushed in a certain direction.

At first the explanation and idea behind identifying these levels seems easy, but as you'll find out, support and resistance can come in various forms and it is much more difficult to master than it first appears. (To learn more, read Analyzing Chart Patterns and Basics Of Technical Analysis.)

The Basics
Most experienced traders will be able to tell many stories about how certain price levels tend to prevent traders from pushing the price of an underlying asset in a certain direction. For example, assume that Jim was holding a position in Amazon.com (AMZN) stock between March and November 2006 and that he was expecting the value of the shares to increase. Let's imagine that Jim notices that the price fails to get above $39 several times over the past several months, even though it has gotten very close to moving above it. In this case, traders would call the price level near $39 a level of resistance. As you can see from the chart below, resistance levels are also regarded as a ceiling because these price levels prevent the market from moving prices upward.

Figure 1

On the other side of the coin, we have price levels that are known as support. This terminology refers to prices on a chart that tend to act as a floor by preventing the price of an asset from being pushed downward. As you can see from the chart below, the ability to identify a level of support can also coincide with a good buying opportunity because this is generally the area where market participants see good value and start to push prices higher again.

Figure 2

Trendlines
In the examples above, you've seen a constant level prevent an asset's price from moving higher or lower. This static barrier is one of the most popular forms of support/resistance, but the price of financial assets generally trends upward or downward so it is not uncommon to see these price barriers change over time. This is why understanding the concepts of trending and trendlines is important when learning about support and resistance. When the market is trending to the upside, resistance levels are formed as the price action slows and starts to pull back toward the trendline. This occurs as a result of profit taking or near-term uncertainty for a particular issue or sector. The resulting price action undergoes a "plateau" effect or slight drop-off in stock price, creating a short-term top. (To learn more, read Track Stock Prices With Trendlines and Short-, Intermediate- and Long-Term Trends.)

Many traders will pay close attention to the price of a security as it falls toward the broader support of the trendline because historically, this has been an area that has prevented the price of the asset from moving substantially lower. For example, as you can see from the Newmont Mining Corp (NEM) chart below, a trendline can provide support for an asset for several years. In this case, notice how the trendline propped up the price of Newmont's shares for an extended period of time.

Figure 3

On the other hand, when the market is trending to the downside, traders will watch for a series of declining peaks and will attempt to connect these peaks together with a trendline. When the price approaches the trendline, most traders will watch for the asset to encounter selling pressure and may consider entering a short position because this is an area that has pushed the price downward in the past. (To learn more, check out Peak-and-Trough Analysis.)

The support/resistance of an identified level, whether discovered with a trendline or through any other method, is deemed to be stronger the more times that the price has historically been unable to move beyond it. Many technical traders will use their identified support and resistance levels to choose strategic entry/exit prices because these areas often represent the prices that are the most influential to an asset's direction. Most traders are confident at these levels in the underlying value of the asset so the volume generally increases more than usual, making it much more difficult for traders to continue driving the price higher or lower.

Round Numbers
Another common characteristic of support/resistance is that an asset's price may have a difficult time moving beyond a round price level such as $50. Most inexperienced traders tend to buy/sell assets when the price is at a whole number because they are more likely to feel that a stock is fairly valued at such levels. Most target prices/stop orders set by either retail investors or large investment banks are placed at round price levels rather than at prices such as $50.06. Because so many orders are placed at the same level, these round numbers tend to act as strong price barriers. If all the clients of an investment bank put in sell orders at a suggested target of, for example, $55, it would take an extreme number of purchases to absorb these sales and, therefore, a level of resistance would be created.

Moving Averages
Most technical traders incorporate the power of various technical indicators, such as moving averages, to aid in predicting future short-term momentum, but these traders never fully realize the ability these tools have for identifying levels of support and resistance. As you can see from the chart below, a moving average is a constantly changing line that smooths out past price data while also allowing the trader to identify support and resistance. Notice how the price of the asset finds support at the moving average when the trend is up, and how it acts as resistance when the trend is down. Most traders will experiment with different time periods in their moving averages so that they can find the one that works best for this specific task. (To read more, see Exploring Oscillators And Indicators and Trading Psychology And Technical Indicators.)

Figure 4

Other Indicators
In technical analysis, many indicators have been developed for to identify barriers to future price action. These indicators seem complicated at first and it often takes practice and experience to use them effectively. Regardless of an indicator's complexity, however, the interpretation of the identified barrier should be consistent to those achieved through simpler methods.

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For example, the Fibonacci retracement tool is a favorite among many short-term traders because it clearly identifies levels of potential support/resistance. The reasoning behind how this indicator calculates the various levels of support and resistance is beyond the scope of this article, but notice in Figure 5 how the identified levels (dotted lines) are barriers to the short-term direction of the price. (For more on this tool, see What is Fibonacci retracement, and where do the ratios come from?, Advanced Fibonacci Applications and Fibonacci And The Golden Ratio.)

Figure 5

Conclusion
Determining future levels of support can drastically improve the returns of a short-term investing strategy because it gives traders an accurate picture of what price levels should prop up the price of a given security in the event of a correction. Conversely, foreseeing a level of resistance can be advantageous because this is a price level that could potentially harm a long position because it signifies an area where investors have a high willingness to sell the security. As mentioned above, there are several different methods to choose when looking to identify support/resistance, but regardless of the method, the interpretation remains the same - it prevents the price of an underlying from moving in a certain direction.

By Casey Murphy,
Access Investopedia's Forex Advisor FREE Report - The 5 Things That Move The Currency Market

Casey Murphy is the senior analyst at ChartAdvisor.com. He contributes educational articles to Investopedia.com and is a graduate of the University of Alberta School of Business. ChartAdvisor is an independent technical analysis service dedicated to uncovering explosive short-term trading opportunities for individual investors. To learn more about how you can start a free trial and put Casey's insightful analysis and expert pattern recognition to work for you, click here now.