The Lawrence Chan Blog

I have just posted a new special update for premium members. You can read it here,

Market Bias Observer Issue 20 (Jul 2013) Special Update 2

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An article offers a good glimpse into the way how Wall Street really works in the 1990s,

Insight: Trades from 1990s come back to haunt Wall Steet

http://ca.reuters.com/article/businessNews/idCABRE97P0BO20130826

All these OTC long term derivatives the big institutions holding should not be created in the first place.

It is no different from AIG writing all those stupid options that blow it up.

Well, I guess some people will do anything as long as they can jack up the earning for next quarter which of course indirectly increases their bonus.

’nuff said.

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Ms. Heffernan’s presentation teaches us, traders, one important thing to always remember – don’t be that 85% wilfully blind crowd, ever.

Sometimes, especially when you are trading a macro idea, that your position would not work out in your favour for a long time.

If you lose yourself, if you fail to stay your course, your trade will lose.

That does not mean everyone should indulge themselves into believing in an illusion. It is important you see through what you think and that logically your beliefs are really correct.

Only when what you believe in is actually what the truth is and that the inevitable course expected actually happens would you reap the profit.

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Hindenburg Omen is a market breadth driven pattern. It is made famous when it has successfully forewarned several times in history on serious stock market sudden corrections. I am going to explain the concept with common sense so that you can make informed decision when you see this term showing up in the news.

Definition of Hindenburg Omen

I am not going to waste time on writing a full article on the subject. You can find a good description of the naming, history and criteria that defines the Hindenburg Omen from Wikipedia. My focus here is to clarify several important points about the concept.

Reasoning Behind

Any predictive forecast model designed to identify potential short term volatility (i.e. wild swings) are measuring some sort of excessive effort made in pushing the market in one direction (in terms of price movement) while other factors are not supporting the effort. Hindenburg Omen focus specifically on potential sudden drop or crash like move in the stock market. Thus it only measures excessive efforts made to push the stock market higher while the overall underlying conditions are not supporting it.

The underlying conditions Hindenburg Omen use are several market breadth statistics. By comparing the number of components demonstrating bullish behaviour against the number of components showing bearish signs, one can tell if the current strength in the up move of the index is justified. As the model is built from observing historical behaviour, the triggering threshold / event from the various statistics are discovered from history. Hence going forward, if the market breadth behaviour changes, it will affect the accuracy of the signal.

Think of Hindenburg Omen as the weather forecast warning that a potential thunderstorm is in the making. This will put you in the correct mindset to interpret the signal.

Like weather forecast, the signals get stronger and more accurate as more evidence present themselves. This, however, does not guarantee a sharp selloff in the market is coming. Using the thunderstorm metaphor, even if all the evidence like huge dark clouds covering the sky completely and that it is raining heavily already, there is still the chance of thunder and lightning not happening.

Great Track Record Coming From A Different Era

Ever since Quantitative Easing started back in 2009, majority of market breadth data has undergone significant changes. I have explained the changes in Advance / Decline Issues already in a separate article. These changes make the market breadth statistics more volatile. The mean reversion behaviour shortened from weeks to days at times.

With changes like this, Hindenburg Omen’s original design can no longer capture majority of the sudden moves in the stock market. The market breadth data it depends on are not sensitive enough. Hindenburg Omen has turned into a warning sign that works under specific conditions only. It is no longer very effective as a general market top warning tool. The main weaknesses is that it cannot produce a precise time window on the potential selloff for market timing purpose.

Going Forward More Sophisticated Analysis Will Do A Better Job

For weather forecasting, technological advancement continues to march forward while nature, the global weather system itself, is still pretty much the same dynamic system we have from hundreds of years ago. The improvement we made to our models on weather behaviour gets us closer to better forecasting ability, no matter how slow the progress has been.

For stock market crash warning system, it does not have the same luxury like our work in weather forecasting. The stock market has evolved significantly beyond what the old style broad based market breadth can offer to detect subtle changes within. The stock market grows bigger, more complex and more diversified everyday. Generic broad based market breadth paints a broad stroke on the stock market that is too broad to be useful.

A good example is the Russell 2000 Index. This index does not correlate much with the 3 major indices (Dow Jones Industrial Average, S&P 500 and Nasdaq 100). Most of the components within Russell 2000 are not even listed in NYSE. It is obvious Hindenburg Omen is of very limited value in forecasting potential market crash in Russell 2000.

Index specific breadth analysis will likely improve the signal quality and timeliness even if a similar framework like the Hindenburg Omen is used. The advantage of such models is that you can extract value from the work done directly. As a start, the predictive ability of the model can be translated into market timing model quite easily as you can target specific tradable market indices like the S&P 500. The disadvantage, of course, is that such targeted signal do not give you the broad market / overall financial system warning like the Hindenburg Omen.

A direction to look for better solution is to look at the transaction level behaviour to look for signs of instability. Work done by Didier Sornette shows us that there is indeed new way in identifying potential financial crisis on a global scale. The catch is that most stock market participants are not scientists thus it will be difficult to make progress in this direction unless more scientists are willing to work on this problem.

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The documentation type articles on premium reports are coming along slowly. Suffering writer’s block at the moment as I have to figure out ways to explain things in easy to understand language. It is a challenge but well worth the time I put into them. Several will be ready soon.

From the many emails I received from newcomers with day trading, it seems that one of the major obstacles is the lack of good basic chart reading skills. Solid chart reading takes time to train but in the meantime the newcomers suffer from the difficult market environment we are facing. I have started posting intraday biases that should help.

The first few ones are on Emini S&P. The next few ones will be on various forex majors. These biases are originally intended to be part of the automated real-time analysis tool on the site. Since my web programmer could not get a working model on the auto update for me yet, it is not a bad idea to post the various setups now.

One thing to remember is that these biases are not there to replace good chart reading skill. They can be used to jump start / shorten the time it takes to become a better trader but they are not the complete solution. Newcomers still need to focus on good discipline and proper money management to take advantage of the knowledge I share.

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