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The Herrick Payoff Index (HPI) uses volume, open inerest, and price to signal bullish and bearish divergences in the price of a future or options contract. The use of open interest in the calculation of the HPI means the indicator can only be used with futures and options. The HPI is based off of two premises regarding open interest:
- Rising Open Interest: When prices rise and open interest rises, this is a bullish and confirming sign of recent price rises. Likewise, when prices fall and open interest rises, this is a bearish and confirming sign of recent falling prices.
- Falling Open Interest: When prices rise and open interest falls, this is considered to be a bearish sign and signal of impending reversal. Similarly, when prices fall and open interest falls, this is considered to be a bullish sign and is a potential reversal signal.
The following chart of crude oil shows HPI divergence signals:
High #1 to High #2
Crude oil made higher highs, yet the Herrick Payoff Index (HPI) made a lower low, which is a bearish divergence. The logic behind the HPI indicator is that there was much trader excitement in crude oil at High #1, characterized by increasing volume and open interest. Even though crude oil prices made a higher high at High #2, volume and open interest changes did not match those price increases on the second high.
The HPI indicator then retreated below the zero line, the bearish price action in crude oil was confirmed. Traders might look for shortsell opportunities.
The HPI indicator then bottomed out and reversed course, soon advancing above the zero line. The zero line crossover confirmed the bullish price action. Traders might be advised to look for buying opportunities.
High #3 to High #4
In yet another bearish divergence, crude oil prices made new highs, yet the HPI indicator failed to confirm the price action, making a lower high. This divergence acted as a warning of a potential price reversal.
The Herrick Payoff Index is an excellent technical analysis tool using volume and open interest to confirm price movement and warn of potential reversals.
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