# Trading Techniques – The Herrick Payoff Index

04/10/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

In an earlier article, I discussed how the action of the open interest should be watched carefully by futures traders. Open interest is the number of contracts or options existing at the end of a trading session. You should note that every contract has a buyer and a seller who together make up one contract. The open interest should be monitored along with the price and volume action to determine whether an up or downtrend is strong or weak. For more on basic open interest analysis, please see my earlier article, Futures Trading – Open Interest.

The Herrick Payoff Index (HPI) was developed by John Herrick and is the only well known indicator that uses price, volume, and open interest. I was fortunate many years ago to witness a very lively debate between John Herrick and James Sibbett, the inventor of the demand index, and the debate revolved around whose indicator was the best. Personally, I never settled the debate for myself, as after using both indicators for several years, I concluded that both were equally valuable.

I find the HPI to be an excellent short- and long-term tool, and I recommend examining it on both a weekly and daily basis. The HPI is simply a mathematical method of measuring the money flowing in or out of a commodity by computing the difference in dollar volume each day. The formula is quite complex (see below) and to my knowledge is currently only available in MetaStock software. The calculation requires two different inputs, the value of a one cent move and a smoothing factor. For a one cent move, I commend 500 for financials and metals with 250 for the rest of the commodities. The standard for the smoothing factor is ten, which relates to a 10-period moving average. The calculation of the Herrick Payoff Index (HPI) is

Where:

The HPI can be analyzed on many levels, and the most simple is to determine whether it is above or below the zero line. If it is above zero, it shows that money is flowing into the market, therefore positive, while if it is below zero it is negative. I have also found that by using a 21-period weighted moving average (21WMA) of the HPI one can more easily identify the trend of the HPI. The third level of analysis is to look for divergences on both a weekly and daily basis as weekly divergences can help one identify intermediate turning points. Daily divergences, if no weekly divergences were evident, would be consistent with corrections within the intermediate trend.

Figure 1Click on Image for a larger version

The first market I would like to take a look at is crude oil, as it has become a focal point for the markets over the past few years with the price of crude now often reported on the nightly news. Veteran futures traders will tell you that 10-15 years ago if crude prices made the regular news, it often meant that crude was close to a turning point, but this is not the case now. This chart covers the last half of 2006 and all of 2007. Taking even a longer-term view of this market is difficult as the dramatic increase in the open interest makes the scaling difficult. From the start, you should note that the HPI is above the zero line for the entire period though it did drop towards the zero line in January 2007. The HPI moved back above its declining 21WMA (point 1) one week before the downtrend in price, line A, was overcome. Crude had just undergone a sizable correction from just above \$79 to the \$57 per barrel level. This brought crude back to the October 2005 lows and was a deep enough correction for many to conclude the rally in crude was over. Crude rebounded over the next six months to the \$74 area before again undergoing a sharp three-week correction. The HPI dropped below its WMA (point 2) but held well above the zero line and four weeks later was back above its WMA (point 3). By September 22, the HPI had made new highs for the year and was leading prices higher. Crude oil accelerated to the upside for the rest of the year and eventually hit a high of \$97.88 a barrel in January 2008. The HPI did confirm the new highs as indicated by line C and, therefore, when the HPI dropped below its WMA in mid-January (point 4) the earlier weekly confirmation of the highs suggested that this was only a correction within an uptrend. It is also interesting to note that the HPI just tested the longer-term uptrend, line B, before moving sharply back above its WMA.

Figure 2
Click on Image for a larger version

The daily chart of June crude oil shows that the HPI moved back above the zero line, and its WMA on January 31, 2007, (line A) two weeks before the downtrend, was overcome. The first daily divergence appeared in June, and the HPI then formed a series of lower highs (line 1). The series of divergences suggested that tighter trailing stops might be a good idea. As noted on the weekly chart, the correction was sharp, but quite brief, which is typical of bull market corrections. One day after the lows on August 23, the HPI moved back above its WMA, and two days later, the HPI overcame its resistance at line 1. By September 7, the HPI had surpassed the prior highs and was acting stronger than prices. Crude stalled in the \$78 area and formed a short-term continuation pattern that was also observable on the HPI. The HPI did drop below its WMA for about eight days before resuming its uptrend. Prices then accelerated to the upside as crude reached the \$93 level in early November (point 3). After a three-day pullback, crude made another new high (point 4), but the daily HPI failed to confirm this price high. Since the weekly HPI had not formed any divergences, this was consistent with a correction within the intermediate-term uptrend, not a major top. The daily correction was confirmed when the HPI’s uptrend (line 2) was broken as it declined sharply into early December. By referring to the weekly data in Fig. 1, you will see that the HPI had started to rebound sharply by early 2008, suggesting that the rally in crude was not over. By February 11, the daily HPI (not shown) indicated the rally in crude oil had resumed.

Figure 3
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The corn market has gotten a lot of press in the past year as it has been in a major bull market. For those of you who do not follow corn, it made multiple tests of the \$2 a bushel levels from 1999 until late 2005 when it began its dramatic rally. From September 2007 until June 2007, it rallied over 50% and then began the period of consolidation noted on the chart above. The HPI declined sharply from the June highs and dropped back below its WMA and the zero line. By late August, the HPI was back above its WMA, and the week of September 22 the HPI moved back into positive territory. However, despite this positive action by the HPI, the correction was not over as prices retreated from the \$4.20 area and tested support in the \$3.70 area. The HPI dropped back to test the zero line on this correction (point 1) but held above it and the rising WMA. Though the price chart shows a series of lower highs during this period (line A), the weekly HPI formed higher highs (line B), which was a bullish indication. In early November, the resistance at line A was overcome as corn prices began their climb to the \$5.50 area. The weekly HPI did form a short-term negative divergence in early 2008 but it was reversed two weeks later.

Figure 4
Click on Image for a larger version

The daily chart of July 2008 corn shows the trading range discussed on the weekly chart, lines C and D. You will note that the daily HPI shows the same surge in late September as apparently significant accumulation was taking place. The daily HPI dropped back below the zero line in early October but by the end of the month was back in positive territory. The price chart shows the completion of the continuation pattern on November 6 (line 1). Prices then moved sideways for over two weeks and then turned higher as the HPI resistance was overcome (point 2). The HPI continued to confirm the new highs until January 15 as corn reached a high of \$5.42. Over the next five weeks, the price chart formed an ascending triangle (dashed lines) while the HPI diverged forming a wedge. This is the period on the weekly chart that I noted previously where the weekly formed a slight negative divergence. The HPI quickly got back in gear with prices as both the weekly and daily HPI did confirm the March 2008 highs.

As you can see from this look at crude oil and corn, the HPI has some nuances which make experience with the HPI more important. In the second part of this article I will look at some further examples of the HPI.

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."