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:
1. 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.
2. 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.
Herrick Payoff Index is considered as a good indicator because it also considers open interest in addition to price and volume. The downsides are it is complex and can only be used with instruments having open interest (futures and options).
The divergences between HPI and price are important signals. Bullish divergence is identified when price is at a new bottom but HPI has a higher bottom than previous bottom. Similarly bearish divergence is identified when price is at a new high but HPI has a lower top.