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How to Play a Stock Market Crash

By Roberto Pedone

WINDERMERE, Florida (Stockpickr) -- Is the stock market on the verge of a major correction? Is the market back in control of those pesky bears? And if so, how should we play it?

That's what on the minds of many market-players, especially those among the technical analysis community. Some traders even believe that another "flash crash" could be right around the corner, because as we move into the most seasonally weak time of the year for equities, the market is flashing two major technical warning signs.

The first warning sign that has the technicians concerned is the technical indicator coined the Hindenburg Omen. The Omen, which uses a number of technical data points to predict a potential stock market collapse, was triggered again on last Friday, marking the second time since Aug. 12 that it's made an appearance.

There are several key technical conditions that trigger the Omen:

  • The daily number of new 52-week highs and the daily number of 52-week lows on the NYSE must both be greater than 79.
  • The daily number of new 52-week highs and the daily number of 52-week lows must both be greater than 2.2% of total NYSE issues traded that day.
  • The NYSE 10-week moving average must be rising.
  • The McClellan Oscillator must be negative on the same day.
  • There number of new 52-week highs must not exceed twice the number of new 52-week lows.
  • Market-players are worried about the second tripping of this Omen because it has been behind every stock market crash since 1987. (Keep in mind, however, that not every second tripping has been followed by a crash. In fact, a crash has occurred only 25% of the times that a second signal has appeared.) According to the Hindenburg Omen, if a crash is to follow this time, it should occur in the next 40 days.

    Even the creator of the Hindenburg Omen, Jim Miekka, a blind mathematician, has made statements to the media recently that he's heeding the warning sign of the Omen and has completely sold all of his stocks. Miekka told the Wall Street Journal -- until the Omen was tripped with a second reading, he had planned to stay in the market until the beginning of September.

    The second major warning sign that is showing up on the charts is what is called a "head and shoulders" chart pattern. This pattern is regarded as a reversal pattern and is most reliable when seen in an uptrend such as we've had recently in the markets. Currently, the S&P 500 has formed a left shoulder at the January high and the head at the April high, and the right shoulder is developing right now.

    The key levels I think investors should be watching on the S&P are the 1040 and 1010 areas. A break below 1040 would almost certainly set up a test of 1010. A move below 1010 would be very bearish and could setup a large drop towards 950 to 860.

    Here's a look at a number of stock and ETF plays for a major market crash.

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