Herrick Payoff Index - Part 1

Intraday trading, or day-trading, must be approached with extreme caution and preparation. It takes research and the application of thorough studies to be fully prepared to jump into the volatile water of intraday price movements. It may seem like simple advice, but a trader must know what indicators to trade with and have a full understanding of how they are derived and applied. If you go in without a plan or too many analysis tools, you’re asking for failure. 

Too many beginners attempt daytrading after asking an unsuccessful long-term trade. They think that somehow being forced to enter and exit the market over short duration will be easier or more rewarding. Many beginners do not take into account that intraday trading takes a greater emotional toll than other trading strategies. While the instant ratification and knowledge that at the end of the day you are “flat” is intuitively pleasing to many traders, as a day-trader you are constantly challenged, every second of the day, with making decisions on researched criteria. A day-trader must create and test a viable system based on chosen and understood indicators. 

A day-trader must have a predetermined market direction from prior research and always use protective stops, or as some prefer, price brackets. This is where tools such as the Herrick Payoff Index (HPI) come into play. The HPI measures trend strength and money fluctuation by analyzing the main components that make up the market (volume, open interest and price). HPI looks to capture the mean prices that are distributed daily. These mean prices mostly are significant points in the market. Significant points are where a trader would find large amounts of volume, open interest and money flow. To understand the HPI, and before we get to calculating the indicator, a trader needs to have a full understanding of volume and open interest. These are the main components that build the indicator. 

Volume and open interest have always been, and will always be, two of the most used but most misunderstood market terms. Volume is the total number of contracts traded at a particular point in time. Whether the trader chooses seconds, minutes or days is irrelevant. HPI looks to break volume up based on the percentage of contracts traded at a particular price. By analyzing this data a trader gets an understanding of where the market is most indecisive, which most likely will be a significant point. 

Volume increases on rallies and decreases on declines in a bull market. Volume increases on declines and decreases on rallies in a bear market. Also, traders will find volume increasing at the breakout points of a trading range. 

Open interest represents the number of outstanding contracts at a particular point in time. A trader can also get a grasp of a market’s liquidity by looking at the amount of open interest and potentially avoid low volume time periods or entire markets to reduce major slippage. 

Open interest usually increases as commercial interest enters the market and commences short selling. Most professional traders will agree that the smart money is always going to be the commercials and by analyzing open interest a trader can look to capture profits from the movement of the market caused by the commercials. 

Traditionally, traders have used the following rules for volume and open interest analysis: 

• If prices are up and volume and open interest are rising, the market is bullish. 

• If prices are up and volume and open interest are declining, the market is bearish. 

• If prices are down and volume and open interest are rising, the market is bearish. 

• If prices are down and volume and open interest are declining, the market is bullish. 

Herrick Payoff Index (HPI) was developed by John Herrick. The HPI is an excellent short- and long-term tool. 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: 

HPI = Ky + ( K - Ky )/ 100000 , where: 

where Ky = yesterday's HPI, 

S = user-entered smoothing factor (0.1 standard), 

y = yesterday's value, and 

K = CV (M – My) (1± 21/G) 

The ± sign in the right bracket of the formula is + if M (mean price) > My (yesterday's mean price); if M 

< My, it is –. 

M =high+low/2, 

C = value of one cent move, V = volume, I = the absolute value of today's open interest minus yesterday's open interest, and G = today's open interest or yesterday's open interest, whichever is greater. 

The Herrick Payoff index is based off a zero line indicating a neutral position. Anything above the zero line or a positive number would indicate an upward trend or a bullish market. Anything below the zero line or a negative number would indicate a downward trend or a bearish market.