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Open Interest
Figure 34-1. Open Interest
Open interest (Ol) reflects the number of all short or long positions inany futures or options market. Open interest depends on the intensity ofconflict between bulls and bears.
Rising Ol shows that the conflict between bulls and bears is becomingmore intense and confirms the existing trend. Rising Ol during uptrendsshows it is safe to add to long positions (A and D). Flat Ol shows thatfewer losers are entering the market. This means that a mature trend isnearing its end and it is time to take profits or tighten stops (B and E).Falling Ol shows that losers are leaving the market and winners are cash-ing in-that a trend is nearing its end. A fire cannot continue when fuel iswithdrawn, and a sharp drop in Ol during a trend signals that a reversalis near (C and F).
At the right edge of the chart, cocoa prices have stabilized after fallingin October and open interest is flat. It shows that the decline in cocoahas shaken out weak bulls and the uptrend is ready to resume. It is timeto go long, with a protective stop below the recent lows.
 
agree about the future course of prices. It takes conviction and disagreementto maintain a trend. Rising open interest shows that the supply of losers isgrowing and the current trend is likely to persist. If open interest increasesduring an uptrend, it shows that longs are buying while bears are shorting34. OPEN INTEREST 181
because they believe that the market is too high. They are likely to run forcover when the uptrend puts a squeeze on them —and their buying will pro-pel prices higher.
If open interest rises during a downtrend, it shows that shorts are aggres-sively selling while bottom-pickers are buying. Those bargain hunters arelikely to bail out when falling prices hurt them, and their selling will pushprices even lower. An increase in open interest gives a green light to theexisting trend.
When a bull is convinced that prices are going higher and decides to buy,but a bear is afraid to sell short, that bull can buy only from another bull whobought earlier and now wants to get out. Their trade creates no new contract,and open interest stays unchanged. When open interest stays flat during arally, it shows that the supply of losers has stopped growing.
When a bear is convinced that prices are going lower, he wants to sellshort. If a bull is afraid to buy from him, that bear can only sell to anotherbear who shorted earlier and now wants to cover and leave. Their trade cre-ates no new contract, and open interest does not change. When open intereststays flat during a decline, it shows that the supply of bottom-pickers is notgrowing. Whenever open interest flattens out, it flashes a yellow light—awarning that the trend is aging and the best gains are probably behind.
Falling open interest shows that losers are bailing out while winners aretaking profits. When their disagreement decreases, the trend is ripe for areversal. Open interest falls when losers abandon hope and get out of themarket without being replaced by new losers. When a bull decides to get outof his long position and a bear decides to cover his short position, the twomay trade with one another. When they do, a contract disappears, and openinterest shrinks by one contract. Falling open interest shows that winners arecashing in and losers are giving up hope. It flashes a red light — it signals theend of a trend.
Trading Rules
A 10 percent change in open interest deserves serious attention, while a 25percent change often gives major trading messages. The meaning of rising,falling, or flat open interest depends on whether prices are rallying, falling,or flat at the time of change in open interest.
1. When open interest rises during a rally, it confirms the ‘uptrend andgives a signal that it is safe to add to long positions. It shows that more182
THE NEGLECTED ESSENTIALS
short sellers are coming into the market. When they bail out, theirshort covering is likely to push the rally higher.
. When open interest rises while prices fall, it shows that bottom-pick-
ers are active in the market. It is safe to sell short because these bar-gain hunters are likely to push prices lower when they throw in thetowel.
. When open interest rises while prices are in a trading range, it is a
bearish sign. Commercial hedgers are more likely to sell short thanspeculators. A sharp increase in open interest while prices are flatshows that savvy hedgers are probably shorting the market.
. When open interest falls sharply while prices are in a trading range, it
identifies short covering by major commercial interests and gives abuy signal. When commercials start covering shorts, they show thatthey expect the market to rise.
. When open interest falls during a rally, it shows that both winners and
losers are getting “cold feet.” Longs are taking their profits, and shortsare covering. Markets discount the future, and a trend that is acceptedby the majority is ready to reverse. If open interest falls during a rally,sell and get ready to sell short.
. When open interest falls during a decline, it shows that shorts are cov-
ering and buyers are taking their losses and bailing out. If open interestfalls during a slide, cover shorts and get ready to buy.
. When open interest goes flat during a rally, it warns that the uptrend is
getting old and the best gains have already been made. This gives youa signal to tighten stops on long positions and avoid new buying.When open interest goes flat during a decline, it warns you that thedowntrend is mature and it is best to tighten stops on short positions.Flat open interest in a trading range does not contribute any new infor-mation.
More on Open Interest
The higher the open interest, the more active the market, and the less slip-page you risk while getting in and out of positions. Short-term traders shouldfocus on the markets with the highest open interest. In the futures markets, itpays to trade the delivery months with the highest open interest.35. HERRICK PAYOFF INDEX 183
Tracking Commitments of Traders reports can help you find outwhether new buying or selling is primarily done by small or large specula-tors or by hedgers (see Chapter 7).
Very few technical indicators use open interest. The Herrick PayoffIndex is the best-known indicator that utilizes it.
35. HERRICK PAYOFF INDEX
The Herrick Payoff Index (HPI) is an indicator developed by John Herrick, atechnical market analyst from California. He taught it privately, but the indi-cator became more popular after it was included in CompuTrac software inthe early 1980s.
The Herrick Payoff Index helps detect accumulation and distribution.Most indicators measure only prices, some measure volume, but HPI tracksopen interest as well as prices and volume. HPI confirms valid trends andhelps catch their reversals.
How to Construct HPI
The Herrick Payoff Index may be calculated using several types of dailydata. You may use a single contract with its own price, volume, and openinterest. It is more practical to combine volume and open interest from allcontracts and apply them to the prices of the most active delivery month.
HPI uses daily high and low prices, volume, and open interest. It requiresdata for at least three weeks before it begins producing meaningful numbers.Its complex formula makes using a computer almost a necessity (see work-sheet, Figure 35-1).
HPI = Ky + (K’-Ky)
where Ky = yesterday’s HPI.K = ((M-M,)* Ce V]> [1 = {+ 2)/G}]and M = mean price—i.e., (High + Low)/2.My = yesterday’s mean price.C = the value of a 1-cent move (or use the same constant forall contracts).V_ = volume.184 THE NEGLECTED ESSENTIALS
 
1/03 108.17
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Figure 35-1. Herrick Payoff index Worksheet
HPI measures changes in prices, volume, and open interest. It is based onmean rather than closing prices-the average consensus of value for theday. The complexity of HPI makes using a computer almost a necessity.
 
I = absolute value of today’s minus yesterday’s open interest.G = today’s or yesterday’s open interest, whichever is less.
The “+” or “—” sign in the right brackets is determined as follows:If M > My, the sign is “+”; if M < My, the sign is “—”.
Traders can apply HPI only to daily data and not to weekly or intradaydata. There is no such thing as weekly open interest. Weekly volume can beobtained by adding up daily volume for five days, but open interest cannotbe added up.
Crowd Psychology
The Herrick Payoff Index measures mean prices rather than closing prices.
Daily mean prices represent the average consensus of value for the day.Volume represents the degree of financial commitment in a given market.
When volume increases, the absolute value of HPI for that day increases.35. HERRICK PAYOFF INDEX 185
Daily changes in open interest represent the flow of funds into and out ofthe market. Rising open interest is bullish in an uptrend and bearish in adowntrend. Falling open interest is bearish in an uptrend and bullish in adowntrend. Flat open interest is essentially neutral.
Trading Rules
The Herrick Payoff Index gives several types of trading signals, listed herein the order of importance. Divergences between HPI and prices identifysome of the best trading opportunities (Figure 35-2). When HPI breaks itstrendline, it gives an early warning that a price trendline is likely to be bro-ken. When HPI crosses its centerline, it confirms new price trends.
1. When prices fall to a new low but HPI makes a higher bottom thanduring the previous decline, it creates a bullish divergence and gives abuy signal. When HPI turns up from its second bottom, buy and placea protective stop below the latest price low.
2. A bearish divergence occurs when prices rally to a new high but HPImakes a lower top. The signal to sell short is flashed when HPI turnsdown from its second top. Place a protective stop above the latest highprice.
Important divergences develop over the course of several weeks. A diver-gence that takes two months to develop is more powerful than the one inwhich two weeks passed between the tops or bottoms. Pay attention to thedifferences in the height of the adjacent HPI tops or bottoms. If the first topor bottom is far away from the centerline and the second top or bottom isnear that line, that divergence is likely to lead to a greater move.
Bullish and bearish divergences of HPI often have long lead times. Onceyou have identified a potential turning point using an HPI divergence, leanon short-term oscillators for more precise timing. If a divergence betweenHPI and price aborts, and you get stopped out, watch closely — you may getan even better trading opportunity if a regular divergence tums into a triplebullish or triple bearish divergence. Triple bullish divergences consist ofthree lower bottoms in prices and three higher bottoms in HPI. Triple bearishdivergences consist of three higher tops in prices and three lower tops inHPI. They occur at some of the major turning points in the markets.
3. HPI lends itself well to classical charting methods, especially trend-lines. When trendlines of prices and HPI point in the same direction,186 THE NEGLECTED ESSENTIALS
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HPI tracks the flow of funds into or out of the market by measuringchanges in prices, volume, and open interest. HPI gives its best signalswhen its patterns diverge from price patterns. HPI identified market topsin August and September by tracing lower peaks while prices rose tonew highs. HPI called market bottoms in October and November whenit stopped declining and bottomed out at more shallow levels while cop-per slid to new lows.
The bullish divergence in November was followed by a breaking of adowntrendline of HPI and a rally above HPI's centerline. This combina-tion gave an especially strong signal to buy copper. The best signalsdevelop slowly and give traders plenty of time to get aboard a newtrend.
 
they confirm trends. HPI often breaks its trendline before prices breaktheirs. When HPI breaks below its uptrend, it gives a sell signal. Whenit breaks above a downtrend, it gives a buy signal. Then it pays toeither take profits or to tighten stops.
4. The position of HPI above or below its centerline shows whether bullsor bears dominate the market. When HPI is above its centerline, itshows that bulls are in control—it is better to be long. When HPI isbelow its centerline, it is better to be short. Bulls may buy or add to36. TIME 187
their long positions when HPI rises above its centerline. When HPIdeclines below its centerline, it confirms downtrends.
36. TIME
Most people conduct their lives as if they intend to live forever—with noreview of the past, no real planning for the future, and minimal learning frompast mistakes. Freud showed that the unconscious mind does not have anotion of time. Our deep-seated wishes remain largely unchanged through-out life.
When people join crowds, their behavior becomes even more primitiveand impulsive than when they are alone. Crowds pay no attention to timeeven though they are affected by its passage. Individuals are ruled by the cal-endar and the clock, but crowds have no notion of time. Crowds act out theiremotions as if they had all the time in the world.
Most traders focus only on changes in prices and pay little attention totime. This is just another sign of being caught up in mass mentality.
The awareness of time is a sign of civilization. A thinking person is awareof time, while someone who is acting impulsively is not. A market analystwho pays attention to time is aware of a dimension hidden from the marketcrowd.
Cycles
Long-term price cycles are a fact of economic life. For example, the U.S.stock market tends to run in four-year cycles. They exist because the rulingparty inflates the economy going into the presidential election once everyfour years. The party that wins the election deflates the economy when vot-ers cannot take revenge at the polls. Flooding the economy with liquiditylifts the stock market, and draining liquidity pushes it down. This is why the2 years before a presidential election tend to be bullish, and the first 12 to 18months following an election tend to be bearish.
Major cycles in agricultural commodities are due to fundamental produc-tion factors, coupled with the mass psychology of producers. For example,when livestock prices rise, farmers breed more animals. When those animalsreach the market, prices fall and producers cut back. When the supply isabsorbed, scarcity pushes prices up, breeders go to work again, and the188 THE NEGLECTED ESSENTIALS
bull/bear cycle repeats. This cycle is shorter in hogs than in cattle becausepigs breed faster than cows.
Long-term cycles can help traders identify-market tides. Instead, mosttraders get themselves in trouble by trying to use short-term cycles for preci-sion timing and predicting minor turning points.
Price peaks and valleys on the charts often seem to follow in an orderlymanner. Traders reach for a pencil and a ruler, measure distances betweenneighboring peaks, and project them into the future to forecast the next top.Then they measure distances between recent bottoms and extend them intothe future to forecast the next low.
Cycles put bread and butter on the tables of several experts who sell ser-vices forecasting highs and lows. Few of them realize that what appears likea cycle on the charts is often a figment of the imagination. If you analyzeprice data using a mathematically rigorous program such as John Ehlers’MESA (Maximum Entropy Spectral Analysis), you will see that approxi-mately 80 percent of what appears like cycles is simply market noise. Ahuman mind needs to find order in chaos—and an illusion of order is betterthan no order for most people.
If you look at any river from the air, it appears to have cycles, swingingright and left. Every river meanders in its valley because water flows faster inits middle than near the shores, creating turbulences that force the river to turn.
Looking for market cycles with a ruler and a pencil is like searching forwater with a divining rod. Profits from an occasional success are erased bymany losses due to unsound methods. If you are serious about trading withcycles, you need a mathematical method for finding them, such as MESA orFourier analysis.
Fourier analysis searches for cycles in very large data samples, but MESAtakes a different tack. It searches for evidence of orderly cyclical movementin a relatively short data window (Figure 36-1). Unlike other packages,which give nonstop trading signals, MESA tells traders that no valid cyclesare present about 80 percent of the time. It aims to recognize cycles as theyemerge from market noise and tells you when a cycle begins to fade.
Indicator SeasonsA farmer sows in spring, harvests in late summer, and uses the fall to get
ready for winter. There is a time to sow and a time to reap, a time to bet onawarm trend and a time to get ready for a cold spell. The concept of seasons36. TIME 189
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Figure 36-1. Price Cycles-Maximum Entropy Spectral Analysis(MESA)
MESA (a method and a software package) shows that cycles are prone toshift and disappear. The narrow window at the bottom of the chart keepstrack of cyclic content. When it is near its upper edge it shows that themarket is chaotic, and when it nears its lower edge it shows that the mar-ket is cycling. A vertical arrow marks a transition from a chaotic to acyclical market.
The square window in the upper left corner shows cyclic content forany date selected by the analyst. It currently shows that a 13-day cycle isrising above the market noise. The jagged line at the right edge of thechart projects the current cycle several days into the future.
 
can be applied to the financial markets. A trader can use a farmer’sapproach. He should look to buy in spring, sell in summer, go short in thefall, and cover in winter. :
Martin Pring developed the model of seasons for prices, but this conceptworks even better with technical indicators. Indicator seasons show youwhere you are in the market cycle. This simple but effective concept helpsyou buy when prices are low and sell short when they are high. It tells you190 THE NEGLECTED ESSENTIALS
when an indicator signal is likely to be strong or weak. It helps you standapart from the market crowd.
The season of any indicator is defined by two factors: its slope and itsposition above or below the centerline. For example, we can apply the con-cept of indicator seasons to MACD-Histogram (see Section 26). We definethe slope of MACD-Histogram as the relationship between two neighboringbars. When MACD-Histogram rises from below its centerline, it is spring;when it rises above its centerline, it is summer; when it falls from above itscenterline, it is autumn; and when it falls below its centerline, it is winter.Spring is the best season for going long, and autumn is the best season forselling short (Figure 36-2).
 
Indicator Slope Position Relative to Centerline Season ActionRising Below Spring Go longRising Above Summer Start sellingFalling Above Fall Go shortFalling Below Winter Start covering
 
When MACD-Histogram is below its centerline but its slope is rising, it isspring in the market. The weather is cool but turning warmer. Most tradersexpect the winter to return and are afraid to buy. Emotionally, it is hard tobuy because the memories of a downtrend are still fresh. In fact, spring is thebest time for buying, with the highest profit potential. Risk is low because aprotective stop can be placed slightly below the market.
When MACD rises above its centerline, it is summer in the market —andmost traders recognize the uptrend. It is emotionally easy to buy in summerbecause bulls have plenty of company. In fact, profit potential in summer islower than in spring and risks are higher because stops have to be fartheraway from the market.
When MACD-Histogram is above its centerline but its slope turns down,it is autumn in the market. Few traders recognize the change and they keepbuying, expecting summer to return. Emotionally, it is hard to sell short inautumn — it requires you to stand apart from the crowd, which is still bullish.In fact, autumn is the best time for selling short. The profit potential is high,while risks can be limited by placing a stop above the recent highs or usingoptions.
When MACD-Histogram falls below its centerline, it is winter in the mar-ket. By then, most traders recognize the downtrend. It is emotionally easy tosell short in winter, joining many vocal bears. In fact, the risk/reward ratio israpidly shifting against bears. Potential rewards are getting smaller and risksare high because stops have to be placed relatively far away from prices.36. TIME 191
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The concept of seasons can be applied to almost any indicator, eventhough this example focuses on the weekly MACD-Histogram. It helpsyou trade in gear with the markets.
Autumn-the indicator is above its centerline but falling. This is thebest season for establishing short positions.
Winter-the indicator drops below its centerline. Use weakness to takeprofits on short positions.
Spring-the indicator turns up from below its centerline. It is the besttime to establish long positions. Notice “a cold spell" in springwhen prices fell to a new low and MACD-Histogram ticked downtemporarily. Do not sell short when MACD-Histogram turns downfrom below its centerline. Do not buy when it turns up from aboveits centerline. A bullish divergence when prices fall to a new lowwhile the indicator makes a more shallow bottom gives a powerfulbuy signal.
Summer-the indicator rises above its centerline. When the weathergets hot, use strength to take profits on long positions.
 
Just as a farmer pays attention to the vagaries of weather, a trader needs topay attention to the vagaries of the markets. An autumn on the farm can beinterrupted by an Indian summer, and a market can stage a strong rally in192 THE NEGLECTED ESSENTIALS
autumn. A sudden freeze can hit the fields in spring, and the market can dropearly in a bull move. A trader needs to use his judgment and apply several ©indicators and techniques to avoid getting whipsawed (see Section 43).
The concept of indicator seasons focuses a trader’s attention on the pas-sage of time in the market. It helps you plan for the season ahead instead ofjumping in response to other people’s actions.
Retracements
Many traders watch price retracements. For example, if a market rallies 120points, traders try to add to long positions when the market retraces 50 per-cent of the preceding move and declines 60 points from the top.
Many floor traders look for a trend to reverse after it retraces 61.8 percentof the previous move. This number is based on the Fibonacci number series.
This idea of measuring retracements can also be applied to time. It pays tomeasure how long each rally and decline have lasted. For example, rallies ina bull market are often interrupted by declines that last approximately half aslong as the preceding rallies. If you discover that rallies tend to last 8 daysand declines 5 days, that knowledge encourages you to look for a buyingopportunity 4 days into a decline.
The Factor of Five
Analysts often feel confused when they look at charts in different timeframesand see that the market is going in several directions at once. The trend maybe up on the daily charts but down on the weeklies, and vice versa. Which ofthese trends will you follow? This becomes even more complex if you lookat intraday charts. Most traders pick one timeframe and close their eyes toothers — until a sudden move outside of “their” timeframe hits them.
The factor of 5 links all timeframes. If you start with monthly charts andproceed to the weeklies, you will notice that there are 4.5 weeks to a month.As you switch to daily charts, you will see 5 trading days to a week. As yourtimeframe narrows, you will look at hourly charts—and there are approxi-mately S—6 hours to a trading day. Day-traders can proceed even further andlook at 10-minute charts, followed by 2-minute charts. All are related by thefactor of 5.36. TIME 193
The proper way to analyze any market is to analyze it in at least two time-frames. They should be related by the factor of 5. When you analyze themarket in two timeframes, the shorter of them has to be five times shorterthan the longer one. If you want to analyze daily charts, you must first exam-ine weekly charts, and if you want to day-trade using 10-minute charts, youfirst need to analyze hourly charts. This is one of the key principles of theTriple Screen trading system (see Section 43).VIStock Market Indicators
 
37. NEW HIGH-NEW LOW INDEX
Stock and futures traders used to live like two separate tribes. They tradeddifferent markets and used different analytic tools. The wall between thembegan to crumble after stock index futures were created in 1982. Both tribesrushed to trade them. An astute trader owes it to himself to master the toolsof both tribes.
Shrewd stock traders use Stochastic, moving averages, and other tools offutures analysts. Futures and options traders can time their stock index tradesbetter by using stock market indicators. They include the New High-NewLow Index (probably the best leading indicator of the stock market), theTraders’ Index (TRIN), and several others.
How to Construct NH-NL
The New High-New Low Index (NH-NL) tracks the numbers of marketleaders. It measures the number of stocks that have reached new highs orlows for the year on any given day. The stocks on the list of new highs arethe leaders in strength, and the stocks on the list of new lows are the leadersin weakness. NH-NL confirms trends when it rallies or falls in gear withprices. It identifies tops and bottoms in the stock market when it divergesfrom prices.
The New High-New Low Index measures daily differences between new
19437. NEW HIGH-NEW LOW INDEX 195
highs and new lows. The New High-New Low Index is easy to calculate byhand, using information from the Market Diary section of most major news-papers.
NH-NL = New Highs — New Lows
New highs and new lows are reported by most data services in the UnitedStates. Make sure that your data vendor calculates new highs and lows overa 52-week period. Some use the ancient “calendar method” and calculatenew highs and lows going back only to January.
Plot the New High-New Low Index as a histogram, with a horizontal ref-erence line at zero level. On the days when there are more new highs thannew lows, NH-NL is positive and plotted above the centerline. On the dayswhen there are more new lows than new highs, NH-NL is negative and plot-ted below the centerline. If the numbers of new highs and new lows areequal, NH-NL is zero.
Crowd Psychology
A stock appears on the list of new highs when it is the strongest it has beenin a year. This shows that a herd of eager bulls is chasing its shares. A stockappears on the list of new lows when it is the weakest it has been in a year.This shows that a crowd of aggressive bears is dumping its shares.
The New High—-New Low Index tracks the strongest and the weakeststocks on the exchange and compares their numbers. It measures the balanceof power between the leaders in strength and the leaders in weakness. This iswhy NH-NL is a leading indicator of the stock market. The broad indexes,such as the S&P 500, tend to follow the trend of NH-NL (Figure 37-1).
You can visualize the 2000 stocks on the New York Stock Exchange as aregiment of 2000 men. If each stock is a soldier, then new highs and newlows are the officers. New highs are the officers who lead the attack up a hill,and new lows are the officers who are deserting and running downhill. Thereare no bad soldiers, only bad officers, say the military experts. The NewHigh-New Low Index shows whether more officers lead the attack uphill ortun downhill.
When NH-NL rises above its centerline, it shows that bullish leadership isstronger. When NH-NL falls below its centerline, it shows that bearish leader-ship is stronger. If the market rallies to a new high and NH-NL rises to a newpeak, it shows that bullish leadership is growing and the uptrend is likely to196 STOCK MARKET INDICATORS
New High-New Low Index
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Figure 37-1. New High-New Low Index
Stocks making new highs for the year are the leaders in strength, andstocks making new lows are the leaders in weakness. NH-NL measuresthe direction and intensity of market leadership by comparing the num-ber of new highs and new lows.
In the summer of 1987, mass bullishness rose to a high pitch, as thebull market roared into its final peak. It was safe to hold stocks as long aseach new high in the stock market was confirmed by a new peak in theNew High-New Low Index (A, B, C, D, and £). The August peak in thestock market was accompanied by a bearish divergence (E-F) in the NH-NL Index, giving a sell signal.
When the stock market declined in September, many traders wentbargain hunting. Five years of rising prices had trained them to usedeclines for buying. NH-NL, meanwhile, pointed to a severe weakness.It peaked out at only 100 (G), indicating weakness. NH-NL turned nega-tive in October (H). It gave repeated sell signals in advance of the his-toric crash.
 
continue. If the market rallies but NH-NL shrinks, it shows that the uptrend isin trouble. A regiment whose officers are deserting is likely to turn and run.
A new low in NH-NL shows that the downtrend is likely to persist. Ifofficers are running faster than men, the regiment is likely to be routed. Ifstocks fall but NH-NL turns up,