What Is the Herrick Payoff Index?

The Herrick Payoff Index is a technical analysis tool that tracks price, volume, and open interest to identify potential trends and reversals in futures and options markets. Traders often use the indicator as a measure of crowd psychology and to follow money flows in order to make forward-looking decisions.

Key Takeaways

  • The Herrick Payoff is a tool used to confirm price trends or reversals in derivatives markets using price and volume information to track money flows.
  • One advantage of the Herrick Payoff Index is that it can produce signals even in the midst of a trending market.
  • However, because it is forward-looking, the Index can also produce false positives, and so should be used in combination with other technical indicators.

Understanding the Herrick Payoff Index

The Herrick Payoff Index takes account of a derivative contract's price, volume, and open interest to generate bullish and bearish signals. Since open interest is used in the calculation, the technical indicator can only be used in options and futures markets. Most traders use the Herrick Payoff Index to measure crowd psychology in the futures and options markets. In those markets, there is less liquidity than the equity markets and more potential for volatility over time.

Bullish continuation signals are generated when prices and open interest rise since traders are increasingly buying into the contract. In addition, a contract may be poised for a bullish reversal when prices and open interest are falling at the same time because selling pressure is declining as prices are becoming increasingly attractive.

Bearish continuation signals are generated when prices are falling, and open interest is rising, since traders are increasingly placing bearish bets. Also, a contract may be poised for a bearish reversal when prices are rising, and open interest is falling, which indicates that bullish traders are losing momentum.

In general, bullish traders are in control when the indicator is above the centerline, and bearish traders are in control when the indicator is below the centerline. However, traders should use the indicator in conjunction with other technical indicators or chart patterns to maximize their odds of placing successful trades.

Using other technical indicators for confirmation can reduce the impact of false signals from the Herrick Payoff Index.

Benefits of the Herrick Payoff Index

One feature of the Herrick Payoff Index is the ability to generate exit signals when trends are still underway. As open interest falls, the Herrick Payoff Index indicates that the ongoing price trend is likely to reverse. With this indicator, traders have the potential to get out before the price even starts to decline. That is very different from many other technical signals, which are lagging indicators. Most notably, any indicator based on moving averages, such as the MACD, will always lag price action in the market.

Exiting a trade before a price drop by using the Herrick Payoff Index yields even larger benefits because its home is in the highly volatile futures and options markets. Since these derivatives use such high degrees of leverage, even a small drop in the underlying security price can easily cause significant losses. For example, a stock price decrease of just 5% can lead to a loss of more than 25% for a call option.

Downsides of the Herrick Payoff Index

The Herrick Payoff Index is, however, often a less reliable guide for entering trades because of the forward-looking nature of its reversal signals. Suppose prices are still declining, but open interest is also falling, as shown by the Herrick Payoff Index. While that may indicate the downward pressure is slowing, it does not mean a rally is imminent. The asset could instead stabilize in price and stay there for a long time. Famous trader Jesse Livermore called such securities "listless drifters," and he actually disliked them more than outright losses that he would typically sell right away.

However, ordinary traders are usually more afraid of losses, which are real possibilities when entering trades based on the Herrick Payoff Index. Buying a security while the price is still falling goes against the common wisdom among speculators that one should not try and catch a falling dagger. Indeed, value investors often try to do just that. However, value investors rarely use technical indicators like the Herrick Payoff Index.

Even with exit signals, there is a heightened danger of a premature move with the Herrick Payoff Index. When lagging indicators send false signals, their followers at least have the consolation of cutting their losses. Since the Herrick Payoff Index sends exit signals when prices are still going up, interest may revive, and the security might just keep going up unimpeded. Letting go of a rising star like that is something that would frustrate many traders, especially those with limited experience.