The Hindenburg Omen

09/25/2014 8:00 am EST

Focus: OPTIONS

Andrew Giovinazzi

Chief Options Strategist, OptionPit.com

Andrew Giovinazzi of OptionPit.com discusses the Hindenburg Omen—and while it can be a ‘spooky’ indicator that options traders are afraid of—it might be something else entirely.

From Wiki:  The Hindenburg Omen

“From historical data, the probability of a move greater than 5% to the downside after a confirmed Hindenburg Omen was 77% [The Wall Street Journal 8/23/2010 article cited below states that accuracy is 25%, looking at period from 1985], and usually takes place within the next forty days. The probability of a panic sellout was 41% and the probability of a major stock market crash was 24%. Though the Omen does not have a 100% success rate, every NYSE crash since 1985 has been preceded by a Hindenburg Omen. Of the previous 25 confirmed signals only two (8%) have failed to predict—at least—mild (2.0% to 4.9%) declines.

Because of the specific and seemingly random nature of the Hindenburg Omen criteria, the phenomenon may be simply a case of over fitting. That is, by back testing through a large data set with many different variables, correlations can be found that do not really have predictive significance. The Omen is—at best—an imperfect technical indicator that is a work in progress.”

It was a topic of conversation Tuesday in the Option Pit Chat Room.  The Hindenburg Omen and whatever gargoyles we could conjure up from the ether to describe the slow and steady rise in VIX.  While it could be this spooky indicator—everyone is afraid of it after all—it might be something else.

A clever client of mine noticed this pattern this year in a relationship between realized and implied volatility.  When short-term 20-Day HV dips way under the 30-Day IV by around 5 points, stocks have had nice little rallies afterward.

chart
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My sense of this is, when there are some lingering worries, the pace of realized volatility slows down and the market sort of freezes up.  Instead of sliding up, it slides down.  Since the direction is south, VIX moves up and traders start to bid up the IV again even though the pace of the moves is kind of slow.  What we get is the HV/IV separation we see in the chart.

The problem with our bull market is the snap rallies are more vicious then the sell-offs so that is cause enough for traders to bid up IV.  That is where we find ourselves today.  Of course, according to the Hindenburg Omen, we can rally short-term and crash within 40 days.  Mark your calendar.

The Trade

The successful trades lately have been upside Broken Wing Butterflies in the SPX.  Place the short leg somewhere above all-time highs and take in a credit.  Keep the duration relatively short and be patient.

By Andrew Giovinazzi, Chief Options Strategist, OptionPit.com

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