Trading Basics – The Herrick Payoff Index, Part 2

04/24/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

In Part One, I discussed the basics of the Herrick Payoff Index, or HPI, providing examples that looked at both the weekly and daily data. Though I always recommend looking at two different time frames, it is particularly important with the HPI as the swings in the open interest (a key component of the HPI) can give you some misleading signals, especially with the daily HPI. In this article, I would like to take you through some further examples that will illustrate the nuances of the HPI, including some examples when the weekly and daily analysis were in sync and others when they were not.

Figure 1
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The first market I would like to look at is Comex gold, basis the June 2008 contract. In early 2007, gold made several tests of the $730 area that corresponded to previous resistance. The weekly chart shows a broad trading range, lines A and B, which formed during this period. The resistance in the HPI (line C) was also well defined as the HPI moved above and below its 21-week WMA several times. For one week in late June, and then again during a three week period in August and early September, the HPI was briefly below the zero line. Gold rallied sharply from the August lows and the week ending September 15, 2007 closed just above resistance at line A. That week, the HPI moved back above its WMA and the following week the HPI confirmed the breakout by overcoming its resistance at line C. For the next two months, the HPI rose very sharply and continued to confirm the new price highs.

Figure 2
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In Figure 2, I have continued the weekly gold chart up through March of 2008. As I pointed out in Part One, because of the HPI scaling, the detail in the HPI is often lost when the time scale is condensed. The main purpose of this chart is to provide a frame of reference for the daily gold chart discussed below. Several points should be noted. As gold rallied above the $850 level in November 2007, the weekly HPI did confirm the new highs as noted by the first blue arrow. For the next six weeks, gold formed a triangle (more on this in the daily chart) and dropped below its WMA for a couple of weeks before resuming its uptrend. In early February 2008, gold reached a high of $946, and this was also confirmed by the weekly HPI (see second blue arrow). In March the HPI accelerated to the upside.

Figure 3

Figure 3
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The daily chart of June Comex gold starts off just after the breakout above weekly resistance ? noted in Figure 1. The early November highs on the daily chart were also confirmed by the HPI as gold began to consolidate its gains. The triangle formation, lines a and b, took about five weeks to complete. The downtrend in the HPI was broken four days before prices broke out to the upside. The HPI moved back above its WMA (line 2), just two days before the triangle was completed. {Editors Note: This same time point is also referenced on the weekly chart, Figure 2.}

The rally in January 2008 took gold to the $928 level and after a brief setback, gold reached the $946 level towards the end of the month. The daily HPI did not confirm these highs, which was a sign that a correction was likely. With no weekly divergences, this should only have been a correction, not something more. The correction traced out a triangle formation (lines d and e). On February 19 (line 2), the triangle formation was completed and the HPI confirmed by moving through resistance at line f. As gold reached the $1000 level in early March, the daily HPI made further new highs (line g). Though the HPI does not always lead the price action, even when it just confirms the price breakouts, it can give you another level of confidence.

Figure 4

Figure 4
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The soybean market has also seen an incredible run with the July 2008 contract rising from a low of 630 to almost 1600 by March of 2008. The weekly chart above covers most of 2007 as the soybeans reached 847 in late February 2007. Even though the March peak was a few cents lower, the HPI was stronger as indicated by line a. This is a behavior I have noticed often with the HPI and other indicators such as the OBV. When a weekly indicator is acting stronger than prices, prices generally catch up. The correction in April took the HPI back below its WMA, but by early May it was again above its moving average (line 1). Over the next two months, soybeans rose almost 20% as prices approached 1000. As indicated by line c, both the July and September highs were confirmed by the HPI. The six-week correction in late July and August caused the HPI to drop below its WMA, making the resulting uptrend, line b, an important level to watch. Through year-end the HPI stayed well above its WMA and confirmed the new highs

Figure 5

Figure 5
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By looking at the daily HPI, the corrections within the major trend are often more easy to identify, but this is not always the case. The resumption of the uptrend, shown on the weekly chart, is where this daily chart begins, line 1. Soybeans gapped higher in late June pushing the HPI sharply higher as the volume was seven times greater than the prior day. The July soybeans continued to rally, closing at 981 on July 13, 2007 but the daily HPI did not confirm these highs as indicated by line a. The ensuing correction took the July soybeans back to the June lows over the next five weeks. Seven days after the lows the daily downtrend in the HPI, line b, was broken, and two days later the HPI moved back above the zero line indicating that money flow was once again positive. With both the weekly and daily HPI above their WMAs, the uptrend was ready to resume. This rally took soybeans to a high of 1046 on September 27 but, once again, the daily HPI formed a short-term negative divergence, line c. Though the correction was short lived it was fairly sharp as the HPI dropped briefly below the zero line. With the positive reading from the weekly HPI, the correction should have been a buying opportunity, but the re-entry point was not very clear as the daily HPI chopped around for several weeks (see circle). When the daily HPI did resume its uptrend in early November, soybeans were already 70 points above the October lows. The daily HPI formed a further corrective pattern in late November and early December, line e, as soybeans corrected to the 1200 level before again accelerating to the upside.

Figure 6

Figure 6
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Sugar is another market that has come to life in the past year as the global commodity boom and worldwide demand spreads to other markets. The weekly chart shows a declining wedge formation (lines a and b) as July 2008 sugar attempted to bottom in the 9.50 area. The lower lows in price, line b, were not confirmed by the HPI as it formed higher lows, line c. The weekly HPI moved back above the zero line in mid-September and then dropped back to its WMA and the zero line as the lows were being tested. The classic bottoming formation in the HPI was completed the week of October 19 (line 1), as sugar closed at resistance, line a. Through the end of the year, the weekly HPI continued to act stronger than prices with July sugar reaching the 11.50 area.

Figure 7

Figure 7
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The daily analysis for July sugar was not nearly as clear, which is one of the reasons I decided to look at sugar.During August, sugar only made marginal new price lows (line b) that were not confirmed by the HPI, line d. The daily HPI moved back into positive territory on September 19, two days before the weekly HPI but looking at the daily price history little advantage was gained. As noted earlier, the weekly HPI completed its bottom formation the week ending October 19, but the daily HPI analysis was not as clear. Throughout October and November the HPI stayed positive and oscillated above and below its WMA and gave few definitive signals. This changed on December 11 as first resistance, line e, was overcome. This was confirmed two days later when longer-term resistance at line c, was also overcome and prices began to accelerate to the upside. Sugar made a high of 15.21 in February 2008 (not shown) and while the weekly HPI did confirm these highs, the daily formed a six-week negative divergence. The daily HPI violated the zero line on March 7, but the weekly HPI confirmed the most recent highs.

So what is the “take home” lesson from this? If you are a commodity trader and have access to the HPI, my suggestion is to at least run a weekly analysis of the most active month of the commodities that you trade. You should track the HPI’s value, the 21-week WMA of the HPI, and the spread between the HPI and its WMA. This will tell you if the money flow is positive or negative (HPI above or below the zero line) as well as the HPI momentum by determining if the HPI is moving above or below its WMA. This should be the first step as the weekly analysis I have found to be the most reliable. Then you will be better able to decide if you also want to analyze the daily HPI as it can often, but not always, help you fine tune your entries and exits.

As always I welcome your feed back on these articles and I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow''''''''s MoneyShow.com Video Network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

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