Volume Oscillators: Force Index, Herrick Payofff Index

Force Index

The Force Index (FI) was developed by successful trader and market technician Dr. Alexander Elder to provide a measurement of the force or power of the bulls behind rallies or of the bears behind declines. The Force Index is a centered oscillator; that is, readings above zero are considered positive, and readings below zero are considered negative.

Formulation

The Force Index is calculated as follows:

(Today's close — yesterday's close) X today's volume

Chart 10.39 Force Index Oscillator, Nasdaq 100Trust ETF

The Force Index is not as good at trend confirmation as some other oscillators, but it is quite effective when used to detect trend divergences or when paired with a trending indicator for trading purposes. Since the Force Index produces a choppy data line, it is usually presented in a smoothed format. The most common method of presentation is a 13-period exponential moving average for intermediate-term analysis. A 2-day exponential moving average is suggested for short-term trading.

The Nasdaq 100 Trust ETF (QQQQ) in Chart 10.39 shows a basic plot of the 13-day exponential moving average of the Force Index. All Force Index charts that follow will employ the 13-day exponential moving average.

Trend Confirmation

The Force Index, unlike many other oscillators, is very volatile, and traders should be aware that at times it does not show clear indications of uptrends or downtrends. Its choppy, volatile nature can cause it to make deep lows in uptrends, as demonstrated by the iShares High Yield Corporate Bond ETF (HYG) in Chart 10.40. It did, however, make lower highs in December 2009 and January 2010 as compared with the spring and summer of 2009, which showed that a correction was near.

Chart 10.40 Force Index Oscillator, Uptrend Reading, iShares High Yield Corporate Bond ETF

Downtrends also tend to show mixed characteristics in a Force Index plot; the Force Index is more heavily influenced by the magnitude of the most recent price movements. The S&P SPDR Select Financial ETF (XLF) in Chart 10.41 shows how the Force Index was very volatile in the fall of 2008 before settling down and tracking closer to the zero line into 2009.

Divergences

The Force Index is a highly effective tool when used to look for divergences between price action and the indicator. Positive divergences occur when price makes a new low but the Force Index makes a higher low. Chart 10.42 shows a very large positive divergence at the November 2008 low for the S&P SPDR Select Retail ETF (XRT). The Force Index began a series of higher lows in October 2008, which gave an indication that the push lower was running out of gas.

The Force Index also spots negative divergences that form when price makes a higher high and the Force Index makes a lower high. Chart 10.43 shows a pronounced negative divergence for the Market Vectors Gold Miners ETF (GDX), which gave an early warning before selling unfolded in early 2010.

Chart 10.41 Force Index Oscillator, Downtrend Reading, S&P SPDR Select Financial ETF

Chart 10.42 Force Index Oscillator, Positive Divergence, S&P SPDR Select Retail ETF

Chart 10.43 Force Index Oscillator, Negative Divergence, Market Vectors Gold Miners ETF

Combining Force Index with Other Indicators

Since the Force Index is a relatively sensitive short- to intermediate-term indicator, it works well when paired with a cumulative trending indicator. In Chart 10.44, the Force Index is paired with the Volume Price Trend indicator. Volume Price Trend in this case acts as a filter for trading signals provided by the Force Index. When Volume Price Trend is in an uptrend (i.e., making higher highs and higher lows), buys will be considered on Force Index crosses up through the zero line, while a downtrending Volume Price Trend (i.e., lower highs and lower lows) indicates short sells, but only when the Force Index crosses down through the zero line.

For the Consumer Discretionary Select Sector SPDR ETF (XLY) in Chart 10.44, note the uptrend on Volume Price Trend (the trend filter), which indicates that only buys should be considered. The arrows show buy signals generated on crosses above the zero line. Note that the volatile nature of the Force Index generates some less-than-optimal signal entry points, but trading along the trend and using the Volume Price Trend indicator helps to reduce the risk of a bad trade.

Chart 10.44 Force Index Oscillator Combined with Volume Price Trend, Buy Signals, Consumer Discretionary Select Sector SPDR ETF

Trade Setup

The Force Index is very good at helping traders spot short-term divergences that can lead to effective trades. In Chart 10.45, note how price for the Market Vectors Steel ETF (SLX) bottomed in October 2009 before advancing into January 2010. As the price of SLX pulled back to its February low, the Force Index showed a positive divergence, while price decreased as volume moved lower. Both were signs that selling momentum was drying up and that the uptrend was ready to resume. A downsloping resistance line could have been drawn to connect the January and February highs. A buy order could have been placed when price closed above the resistance line and the Force Index crossed above the zero line.

Trade Entry

In Chart 10.46, the positive divergence in the Force Index was substantiated on February 16, 2010, as the price of SLX closed above the downsloping resistance line. The Force Index did not cross above zero until February 16, however, so a patient trader would have had to wait a couple of days before entering a long position. An initial protective stop should have been placed below the February 5 low of 51.90.

 Chart 10.45 Force Index Oscillator, Trade Setup on Positive Divergence, Market Vectors Steel ETF

Chart 10.46 Force Index Oscillator, Trade Entry on Positive Divergence, Market Vectors Steel ETF

The extra time it took for the Force Index to confirm the price action was well worth it, as price advanced roughly 20 percent from that entry point.

Trader Tips

The Force Index is normally smoothed with a 2- or 13-period exponential moving average to make it easier to use for the following:

• Spotting trend divergences and generating buy and sell signals in the direction of the larger-degree trend
• Giving a quick, short-term read on bullish or bearish control of the market
• Signaling that price direction will continue

Herrick Payoff Index

The Herrick Payoff Index (HPI) analyzes price, volume, and Open Interest to determine the amount of money flowing into and out of a futures contract. The HPI uses the mean or average price for each day as its starting point and then includes volume and Open Interest in its calculations to measure the amount of money flowing into or out of the contract. This oscillator can be applied only to futures contracts because Open Interest is a component in its calculation.

Formulation

The Herrick Payoff Index is rather complex in its calculation. A number of charting applications already have the Herrick Payoff Index included (e.g., MetaStock), which provides ease of use on any futures contract where price, volume, and open-interest data are available.

As a direct consequence of using volume in the calculation, one of the strengths of the HPI is its ability to give a trader an early warning of a change in the price trend. (Remember: Volume precedes price!) Adding Open Interest into the calculation also provides information on whether or not traders are entering or exiting the market, which helps to determine whether a trend is likely to continue or whether it will change direction.

The HPI is a centered oscillator with values above the zero line that signal a bullish money flow into a futures contract and values below the zero line that signal a bearish outflow. Chart 10.47 shows a basic plot of the Herrick Payoff Index for crude oil.

Chart 10.47 Herrick Payoff Index, Crude Oil Continuous Daily

Trend Confirmation

Just as with many other oscillators and indicators, the HPI tends to peak and trough at different ranges in uptrends and downtrends. Chart 10.48 shows how the HPI for continuous copper makes shallow bottoms just below the zero line and peaks well above the zero line in its 2009 uptrend. The opposite is true during downtrends, as the HPI peaks at or just above the zero line while making troughs well below the zero line. Chart 10.49 shows these characteristics during the 2008 downtrend for continuous copper.

Divergences

The HPI is a great oscillator for alerting traders to the current health of a trend. A bullish divergence occurs when price makes a new low and the HPI does not. A bearish divergence occurs when price makes a higher high and the HPI does not. Chart 10.50 shows a bearish divergence for continuous contract gold, as price made a higher high in December 2009, but the HPI did not. This non-confirmation alerted traders that a near-term pullback was developing.

A bullish divergence occurs when price makes a new low, but the HPI does not. Chart 10.51 shows how traders of continuous soybeans would have been alerted to a pending change of direction at the December 2009 low.

Chart 10.48 Herrick Payoff Index, Positive Range during Uptrend, Copper Continuous Daily

Chart 10.49 Herrick Payoff Index, Negative Range Confirms Downtrend, Copper Continuous Daily

Chart 10.50 Herrick Payoff Index, Negative Divergence, Gold Continuous Daily

Chart 10.51 Herrick Payoff Index, Positive Divergence, Soybeans Continuous Daily

Note how price made a new low, while the HPI actually began to move higher. This divergence preceded a powerful rally.

Using HPI with Other Indicators

Since HPI is a centered oscillator usually good for short-term to intermediate-term signals, it pairs well with a long-term trending indicator. In the example of continuous silver in Chart 10.52, HPI is paired with the Accumulation/Distribution indicator. Accumulation/Distribution will give a sense of the prevailing trend and its strength, and the HPI can be used to show the trader when the prevailing trend is ready to resume following price pullbacks.

Note in the chart how the Accumulation/Distribution line held its low while price entered a deep correction. That showed that overall selling pressure was not very strong. The HPI then showed a positive divergence as silver made a reactionary low in July 2009, which alerted traders that the larger-degree uptrend was ready to resume. This is another example of how pairing a short-term to intermediate-term oscillator with a long-term trending indicator can be very effective.

Chart 10.52 Herrick Payoff Index Combined with Accumulation/Distribution, Positive Divergence, Silver Continuous Daily

 Chart 10.53 Herrick Payoff Index, Positive Divergence Trade Setup, Crude Oil Continuous Daily

Trade Setup

One aspect of the HPI we have not yet examined is its ability to be used as a trade trigger, with crosses above the zero line showing bullish money flows while crosses below the zero line show bearish money flows. In Chart 10.53, note how crude oil had been in an uptrend throughout 2007 before pausing in a three-month consolidation that lasted into February 2008. As price traded back down to the bottom of the range in early February, note how the HPI formed a positive divergence, making a higher low while price touched the bottom of its consolidation range.

That was a very good setup, allowing a trader to take a chance on a long trade while using a tight stop just below the consolidation pattern. If price had broken through the bottom of the consolidation pattern, the trade would have been stopped out. A downsloping resistance line was drawn to connect the tops of January and February. A long position would be entered on a close above that line and a cross above the zero line in the HPI. This would provide confirmation between price and the HPI.

Trade Entry

Chart 10.54 zooms in on the time frame in which the buy for continuous crude oil was triggered. Price broke above its resistance line along with a cross

Chart 10.54 Herrick Payoff Index, Positive Divergence Trade Entry, Crude Oil Continuous Daily

above the zero line in the HPI on February 8, 2009. This showed a price break through resistance accompanied by positive money flows into crude oil. Price actually had not broken out of its 3-month consolidation range; however, a trade like this has tremendous upside with minimal risk, as the initial protective stop was placed just below the bottom of the trading range. Should price break lower out of the range, the trade would be stopped out. If price were to break higher on a resumption of the uptrend, it would be a great trade. Price did continue higher up to 110 from the February 8 close of 91.77.

Trader Tips

The HPI is an oscillator that is specifically applicable to futures contracts and that is used for the following:

• Showing bullish and bearish divergences with price
• Giving buy and sell signals crosses above and below its zero line
• Showing trending money flow characteristics as it peaks and troughs in different ranges

One drawback of the HPI is that it requires Open Interest in its calculation, which limits its use to futures contracts.