Herrick payoff index: Meaning, Criticisms & Real-World Uses

What Is Herrick Payoff Index?

The Herrick Payoff Index is a forward-looking technical analysis tool used primarily in derivative markets to assess the strength of money flow and anticipate potential trend reversals. This indicator incorporates three key data points: price, trading volume, and open interest, aiming to provide a comprehensive view of market activity⁴³. The Herrick Payoff Index helps traders gauge underlying market conviction by illustrating whether capital is flowing into or out of a particular futures or options contract⁴².

History and Origin

The Herrick Payoff Index was developed by John Herrick in the 1970s. Herrick, a notable figure in technical analysis, recognized the need for a more comprehensive indicator that could capture both price and volume dynamics in the derivatives market. He sought to combine these elements with open interest, believing that such an integration would offer a more accurate assessment of market sentiment and help forecast future price movements⁴¹,⁴⁰. His work contributed to the broader field of quantitative tools used by traders to understand market mechanics.

Key Takeaways

The Herrick Payoff Index is a technical indicator that measures money flow in futures and options contracts.³⁹
It uniquely combines price, volume, and open interest, offering insights into market conviction beyond what simple price charts provide.
A positive Herrick Payoff Index generally indicates money flowing into the market (bullish trends), while a negative value suggests money flowing out (bearish trends).³⁸,³⁷
The index can signal both trend continuations and potential reversals, often anticipating price shifts by a day or two.³⁶,³⁵
While forward-looking, the Herrick Payoff Index can produce false signals and is best used in conjunction with other indicators for confirmation.³⁴,

Formula and Calculation

The precise formula for the Herrick Payoff Index can vary slightly depending on the software or platform used, but its core principle involves calculating the interplay of price, volume, and open interest.³³ Generally, it measures the change in an averaged price (often a high-low average) multiplied by volume and then adjusted by a factor related to the change in open interest.

A common representation of the underlying calculation involves:

\text{HPI} = \left( \left( P_{\text{avg}} - P_{\text{avg-prev}} \right) \times \text{Volume} \right) \times \left( \frac{1 + \frac{\left| \text{OI} - \text{OI}_{\text{prev}} \right|}{\text{min}(\text{OI}, \text{OI}_{\text{prev}})}}{\text{Divisor}} \right)

Where:

(P_{\text{avg}}) = Current day's average price (e.g., (High + Low) / 2)
(P_{\text{avg-prev}}) = Previous day's average price
(\text{Volume}) = Current day's trading volume
(\text{OI}) = Current day's open interest
(\text{OI}_{\text{prev}}) = Previous day's open interest
(\text{Divisor}) = A scaling factor (e.g., value of a 0.01 move, often user-defined)³²,³¹,³⁰

The result is often smoothed using a multiplier, similar to a moving average ²⁹,²⁸. It is important to note that since the Herrick Payoff Index utilizes open interest, it is specifically applicable to futures and options markets, where open interest data is available.,²⁷

Interpreting the Herrick Payoff Index

Interpretation of the Herrick Payoff Index centers on its relationship to the zero line and its divergence from price action. When the Herrick Payoff Index is above zero, it indicates that money is flowing into the futures contract, suggesting bullish sentiment. Conversely, when the index falls below zero, it signals that money is flowing out, indicative of bearish sentiment. The magnitude of the index also matters; a value far above or below zero suggests a stronger, potentially more sustainable trend²⁶,²⁵.

A key aspect of using the Herrick Payoff Index involves identifying divergences. For instance, if prices are making new highs but the Herrick Payoff Index is failing to confirm these highs (i.e., making lower highs), it can signal a bearish divergence, warning of a potential reversal in the upward trend. Similarly, if prices are making new lows but the index is making higher lows, it could indicate a bullish divergence, suggesting an impending upward reversal²⁴,²³. This makes the Herrick Payoff Index a valuable tool for anticipating shifts in market momentum and evaluating the underlying commitment of market participants²².

Hypothetical Example

Imagine a trader, Sarah, analyzing the futures market for crude oil. She observes that the price of crude oil futures has been steadily rising for several days, signaling a strong upward trend. To confirm the strength of this trend and look for potential reversals, she consults the Herrick Payoff Index.

On Monday, the average price of the crude oil future was $70, with a volume of 50,000 contracts and open interest of 200,000 contracts. The Herrick Payoff Index for Monday registered a positive value of +150, indicating continued money flow into the contract.

On Tuesday, the average price rises further to $71. However, Sarah notices that the volume has decreased to 40,000 contracts, and, more importantly, the open interest has fallen to 190,000 contracts. When she calculates the Herrick Payoff Index for Tuesday, despite the price increase, the index drops to +50. This divergence, where the price is still rising but the money flow (as indicated by the Herrick Payoff Index) is diminishing due to falling volume and open interest, suggests that the bullish momentum is waning. This could be an early warning sign that the current upward trend in crude oil futures might be nearing exhaustion, prompting Sarah to consider tightening her stop-loss orders or taking some profits. This exemplifies how the Herrick Payoff Index provides deeper insights into market liquidity and underlying strength beyond just observing price changes.

Practical Applications

The Herrick Payoff Index is primarily applied in the analysis of futures contracts and options contracts because its calculation relies on the availability of open interest data. Traders and analysts use it to:

Confirm Trends: A rising Herrick Payoff Index alongside rising prices can confirm a strong bullish trend, indicating new money is entering the market. Conversely, a falling index with falling prices can confirm a strong bearish trend²¹.
Identify Divergences: As highlighted in interpretation, divergences between price and the Herrick Payoff Index can act as early warning signals for potential trend reversals. For example, if prices are trending higher but the Herrick Payoff Index is moving lower, it suggests that the underlying buying pressure is weakening.²⁰,¹⁹
Gauge Market Sentiment: The index provides insight into the conviction of market participants. An increasing index suggests growing conviction among buyers, while a decreasing index may signal waning enthusiasm or growing bearish sentiment.¹⁸
Supplement Other Indicators: Given its unique combination of price, volume, and open interest, the Herrick Payoff Index can be used to cross-reference signals from other technical indicators, providing a more robust analytical framework. For instance, comparing the index's signals with information from the weekly Commitments of Traders (COT) report, published by the Commodity Futures Trading Commission (CFTC), can offer further insights into market positioning by different categories of traders. The CFTC publishes these reports weekly, detailing aggregated holdings of participants in U.S. futures markets and breaking down open interest by various trader classifications¹⁷.

Limitations and Criticisms

Despite its utility, the Herrick Payoff Index has certain limitations. Like any technical indicator, it is not infallible and can sometimes produce false signals¹⁶,. This can lead to premature exits from profitable positions or early entries into trades that do not materialize as expected, potentially resulting in losses. Therefore, relying solely on the Herrick Payoff Index for trading decisions is generally not advisable.

Another criticism relates to the subjectivity involved in its calculation. The formula may not be standardized across all platforms, and the selection of inputs like the "value of a .01 move" or smoothing multipliers can introduce biases affecting the index's accuracy¹⁵,¹⁴,¹³. Furthermore, the Herrick Payoff Index's reliance on accurate and timely data for price, volume, and open interest means that any inaccuracies or delays in this underlying data can significantly impair its reliability¹²,¹¹.

Finally, the concept of predicting market turns, which the Herrick Payoff Index attempts, aligns with the broader challenge of market timing. Many experienced investors and financial principles, such as those advocated by the Bogleheads community, suggest that consistently timing the market is exceedingly difficult, if not impossible, for most individuals over the long term, and often leads to missed opportunities¹⁰,⁹. While the Herrick Payoff Index offers a sophisticated approach to this, it does not eliminate the inherent challenges and risk management considerations associated with predictive trading strategies.

Herrick Payoff Index vs. Open Interest

While the Herrick Payoff Index heavily incorporates open interest in its calculation, the two are distinct concepts and serve different analytical purposes.

Open Interest: This is a raw data point representing the total number of outstanding futures contracts or options contracts that have not yet been settled, exercised, or expired. It reflects the total number of open positions in a given market. An increase in open interest typically indicates new money flowing into the market, while a decrease signifies money flowing out as positions are closed. Open interest is often used to gauge market liquidity and the level of participation in a contract.⁸,
Herrick Payoff Index: This is a derived technical analysis indicator that uses open interest, along with price and volume, to provide a more nuanced measure of money flow and market conviction. It is designed to interpret how changes in open interest, in conjunction with price and volume, translate into bullish or bearish pressure. Unlike raw open interest, the Herrick Payoff Index generates a single value that can be plotted over time to identify specific signals, such as divergences and potential trend reversals.⁷,⁶

In essence, open interest provides a snapshot of market participation, whereas the Herrick Payoff Index attempts to synthesize that information with other variables to offer a predictive or confirmatory signal about the market's directional strength.

FAQs

What type of markets can the Herrick Payoff Index be used in?

The Herrick Payoff Index is specifically designed for and used in derivative markets, such as futures and options. This is because its calculation requires open interest data, which is readily available for these contract types.,⁵

Can the Herrick Payoff Index predict market bottoms and tops?

The Herrick Payoff Index can help identify potential market tops and bottoms by signaling divergences between price and money flow. For example, if a market is making new price highs but the index indicates decreasing money flow, it could suggest a potential top and subsequent trend reversals. However, like all indicators, it is not always accurate and should be used with other analytical tools.⁴,³

Is the Herrick Payoff Index a leading or lagging indicator?

The Herrick Payoff Index is generally considered a forward-looking or leading indicator because it attempts to anticipate future price movements by identifying shifts in underlying money flow and market conviction. It can often provide signals a day or two before a significant change in price trend.²,,¹ This contrasts with lagging indicators, such as many moving average based tools, which confirm trends after they have already begun.