S I L V E R R A L L Y A H E A D

THE HERRICK PAYOFF INDEX AND SILVER

One of the first things a commodity trader learns about is the importance of volume and open interest in addition to price. In theory a move, up or down, in price is more convincing and has greater staying power if it is accompanied by an increase in both volume and open interest. Volume is, of course, the number of contracts changing hands during a session, while open interest is the number of contracts carried or held overnight. Since there is risk of adverse over-night and overseas exposure in holding over-night, increasing open interest represents greater conviction or confidence than volume alone. (There are other ways of analyzing open interest, including the currently popular approach of Stephen Briese of Bullish Review which attempts to determine whether strong hands or weak hands are in control of a market).

John Herrick developed the index bearing his name to combine these elements of price, volume and open interest in such as way as to estimate how strong a move is by whether volume and open interest confirm a price move, and to signal when a move is becoming weak and may be ripe for a trend change. Since day to day random events can cause oscillators to misdirect, Herrick adapted the variable error correction moving average (VECMA), originated in missile tracking systems, to track changes in total market value over a given time range. One sums the "tracking errors" rather than the changing price itself. (My best reference is to the now out of print CompuTrac /PC manual. Another brief description is found in "Technical Analysis from A to Z" by Stephen B. Achelis, 1995, ISBN 1-55738-816-4.)

The silver chart is constructed using the CSI three month forward Perpetual Comex Silver contract. This contract corrects for the fact of frequent contract expiration by eliminating the futures premium bias. Total volume and open interest for all existant silver contacts is used. Herrick used a similar system but also often calculated the index for individual contracts as well.

The chart shows the often major divergences of the Herrick Payoff Index (HPI) before price trend change. Some of these divergences can go on for a very long time, as from early December 1994 to March 1995, But others can develop relatively quickly as in the April 1995 silver top.

Interestingly, with a similar positive
divergence in early 1993, the "poor
man's gold" soared more than 53% in a
little more than five months.

At the present time we have a bullish divergence which has been operative since September of 1996. Also the HPI has come up above the "0" line. Both of these features virtually guarantee at least a tradable rally. In addition the shape or form of the HPU line resembles that found just before the big rally in March and April of 1995. What this chart shows is that bearish conviction waned as silver made lower lows after September. Although gold has a similar chart, the patterns in silver are generally clearer since there are fewer venues for silver than gold, and silver trades less in the derivatives and OTC market than does gold. Silver's clearer picture may also reflect its more bullish posture as measured by the recent breakout in the gold silver ratio.

The chart was drawn and converted to the JPEG graphics format with the new MetaStock for Windows 95 and NT, Equis International, 3950 South 700 East, Salt Lake City , UT 84107, USA.

Similar Positive (bullish) Divergence Seen in 1993

The same positive (bullish) divergence was present in 1993, but because of the explosive move after March 1993, the scale is distorted (greater) so the divergence does not show up as well graphically. I CAN assure you though that I have used this techniques (HPI) since the early 1980's and it very rarely ever fails to predict a trend change. It can be very early, as I showed, but it will not give a false reading and almost always gives a true one. Therefore, we c-a-r-e-f-u-l-l-y predict history could repeat based upon historical precedent.

Interestingly, with a similar positive divergence in early 1993, the "poor man's gold" soared more than 53% in a little more than five months.

Dr. Thomas "Aurophile" Drake publishes Gold FaxLetter. Information regarding GFL and other Tenorio Research products is available via tedrake@ibm.net or raymond_merriman@msn.com.

A U R O P H I L E

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