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Technical Analysis of the Financial Markets — John J. Murphy
Macro Overview & Strategic Value
Appendix A (contributed by Thomas E. Aspray) supplements the book’s core indicator set with four advanced tools — the Demand Index, Herrick Payoff Index, Starc Bands, and Keltner Channels — each built to extract more refined signal from the price/volume/open-interest data already covered in earlier chapters, rather than introducing entirely new data inputs. The core thesis is that combining price with volume or open interest in more sophisticated ratio-based constructions can reveal divergences earlier and more reliably than simpler single-variable tools, while volatility-scaled bands (built on Average True Range) provide a more statistically grounded alternative to the fixed-percentage envelopes covered in Chapter 9.
This matters to a practitioner because these tools are explicitly positioned as refinements, not replacements — the Demand Index and Herrick Payoff Index extend the volume/open-interest confirmation logic from Chapter 7 into indicators whose own trendlines can break ahead of price trendlines, giving earlier entry/exit signals than waiting for a price-based break alone. Similarly, Starc Bands and Keltner Channels operationalize volatility itself as the sizing input for overbought/oversold or breakout bands, rather than relying on a fixed percentage or standard deviation.
Structurally, the appendix reinforces the book’s consistent emphasis on divergence as the master signal-detection principle — every tool introduced here is used primarily to spot disagreement between an indicator and price, extending the divergence logic first established with OBV (Chapter 7) and oscillators (Chapter 10) into new, more specialized constructions.
Core Concepts & Mechanics
- Demand Index (DI) as a buying/selling pressure ratio — Combines price and volume into a ratio of Buying Pressure to Selling Pressure, oscillating around a zero line; positive values indicate dominant buying pressure, negative values dominant selling pressure, and divergences between DI and price are the primary trading signal.
- DI trendline lead time — Because the DI can be plotted as a continuous line, standard trendline analysis can be applied directly to the indicator itself; DI trendline breaks have been observed to precede corresponding price trendline breaks by a meaningful margin, giving earlier entry signals than waiting for the price chart alone.
- Herrick Payoff Index (HPI) and open-interest money flow — Combines price, volume, and open interest to gauge money flow into or out of a futures market; positive readings indicate rising open interest supporting rising prices (genuine new capital), while negative readings suggest capital is flowing out — extending Chapter 7’s open-interest durability framework into a single combined indicator.
- HPI whipsaw tendency on daily data — The HPI crosses its zero line frequently on daily charts before a longer-lasting buy or sell signal firms up, meaning traders should expect multiple short-lived crossings and treat early signals with caution until a sustained directional move develops.
- Weekly data preference for both DI and HPI — Both indicators produce fewer false signals when applied to weekly rather than daily data, directly echoing the book’s broader Chapter 8 principle that longer time frames yield more reliable, less noisy signals.
- Average True Range (ATR) as the volatility foundation for both banding systems — True Range captures the greatest of (today’s high-low), (yesterday’s close to today’s high), or (yesterday’s close to today’s low); ATR (its multi-period average) is the shared volatility input scaling both Starc Bands and Keltner Channels, replacing fixed-percentage envelope width with a market-adaptive measure.
- Starc Bands as an overextension/risk filter (not a breakout system) — Built from a doubled 15-period ATR added to/subtracted from a 6-period moving average; prices reaching the starc+ band mark a high-risk buying/low-risk selling zone, and prices at starc- mark the reverse — used to avoid chasing extended moves rather than to generate breakout entries.
- Keltner Channels as a breakout confirmation system — Built from a doubled 10-period ATR added to/subtracted from a 20-period EMA; a close beyond the plus band signals a bullish volatility breakout, a close below the minus band signals bearish — functioning, per Murphy’s contributor, as essentially a graphical version of the four-week channel breakout system from Chapter 9.
- 20-period EMA as dynamic support/resistance within Keltner Channels — After a breakout signal, the middle EMA line itself often acts as a support (in an uptrend) or resistance (in a downtrend) level for subsequent pullback entries, giving the channel a secondary use beyond the initial breakout trigger.
Technical Terminology & Reference Table
| Term | Operational Definition |
|---|---|
| Demand Index (DI) | Volume/price-based ratio of Buying Pressure to Selling Pressure, oscillating around zero |
| Buying Pressure (BP) / Selling Pressure (SP) | Component values in the DI formula; BP=Volume or Volume/%price-change depending on price direction |
| Herrick Payoff Index (HPI) | Indicator combining price, volume, and open interest to measure money flow in futures markets |
| Average True Range (ATR) | Multi-period average of True Range; volatility measure underlying Starc Bands and Keltner Channels |
| True Range | Greatest of: today’s high-low, yesterday’s close to today’s high, or yesterday’s close to today’s low |
| Starc Bands | Stoller Average Range Channels: 6-period MA ± (2 × 15-period ATR); overbought/oversold risk filter |
| Keltner Channels | 20-period EMA ± (2 × 10-period ATR); volatility breakout confirmation bands |
| Volatility Average (VA) | 10-day average of the two-day price range (highest high − lowest low); used in the DI formula constant K |
The Author’s Market Philosophy
The contributor’s model treats price alone as an incomplete data set — genuine conviction behind a move can only be confirmed by layering in volume (DI) or open interest (HPI), consistent with the book’s recurring theme that volume/open-interest analysis reveals whether a trend is durable or fragile. The repeated emphasis on divergence as the primary signal across both indicators reflects an assumption that indicator behavior can lead price behavior — meaning genuine edge comes from monitoring the indicator’s own trend (via trendlines drawn directly on DI or HPI) rather than waiting for price confirmation alone. The shift from fixed-percentage bands to ATR-based bands reflects an assumption that volatility itself is time-varying and market-specific, and that a properly adaptive band should scale automatically to current conditions rather than applying a static percentage across all regimes — directly extending the Bollinger Band logic from Chapter 9 to alternative constructions with different intended uses (risk-filtering vs. breakout confirmation).
Systemic & Portfolio Integration
The DI and HPI extend Chapter 7’s volume/open-interest confirmation logic into standalone divergence-detection tools that can generate earlier systematic entry/exit signals than price-only trend or pattern analysis, directly feeding into position-timing decisions within a broader trend-following framework. Starc Bands function as a systematic risk-management filter — preventing entries at statistically extended, high-risk price levels — while Keltner Channels operationalize the Chapter 9 breakout-system concept using a volatility-adaptive band, giving systematic traders a mechanical, ATR-scaled alternative to fixed-percentage or Donchian-style breakout triggers.
Important Formulas, Data, or Initial Examples
- Demand Index formula: DI = BP/SP. If prices rise: BP = Volume, SP = Volume/P (P = % price change, adjusted by constant K); if prices decline, BP and SP swap roles. K = (3 × Closing Price) / Volatility Average (VA), where VA is the 10-day average of the 2-day high-low range. If BP > SP, DI is inverted (SP/BP) to keep the ratio bounded.
- Starc Bands formula: Upper (starc+) = 6-period MA + (2 × 15-period ATR); Lower (starc-) = 6-period MA − (2 × 15-period ATR).
- Keltner Channels formula: Upper = 20-period EMA + (2 × 10-period ATR); Lower = 20-period EMA − (2 × 10-period ATR).
- T-Bond DI divergence example: bond prices fell from 104 to ~96 (April-November 1994) while the DI formed higher lows — a bullish divergence later confirmed by a zero-line cross.
- GM DI trendline-lead example: a DI downtrend line broke roughly one week before the corresponding price downtrend line broke in late 1995, illustrating earlier entry timing from indicator-based trendlines.
- Gold Starc Bands example: gold overshot the starc- band in February 1997 (a weak but not attractive sell point); three weeks later it had risen $22 to the starc+ band, marking a lower-risk selling opportunity.
- Copper Keltner Channel example: a close below the minus band in late October 1997 preceded a 16-cent decline over the following two months.
Active Recall Evaluation
- Explain why Starc Bands and Keltner Channels, despite both being built from Average True Range, are used for functionally opposite trading purposes.
- Why does plotting the Demand Index as a continuous line (rather than a histogram) enable a specific analytical technique not otherwise available, and what practical timing advantage does it provide?
- What is the underlying logic connecting rising open interest to a positive Herrick Payoff Index reading, and why does this matter more in futures than in equities?
- Why do both the Demand Index and Herrick Payoff Index produce more reliable signals on weekly rather than daily data?
- Describe the secondary use of the 20-period EMA within the Keltner Channel system once an initial breakout signal has already been given.
Answer Key (spoiler)
- Starc Bands are explicitly designed as an overextension/risk filter — reaching the starc+ band flags a high-risk time to buy (not a signal to buy the breakout), and reaching starc- flags a high-risk time to sell — treating band touches as exhaustion warnings; Keltner Channels are instead designed as breakout confirmation tools, where a close beyond the band is interpreted as the start of a new volatility-driven trend move to be traded in the breakout’s direction — the shared ATR construction measures the same underlying volatility, but one system uses band contact as a caution signal while the other uses it as a green light.
- A histogram only shows discrete bar values and doesn’t lend itself to connecting sequential peaks or troughs with a drawn line; plotting the DI as a continuous line allows the same trendline-drawing technique used on price charts to be applied directly to the indicator itself, and because indicator trendlines have been observed to break before the corresponding price trendline breaks, this gives a trader an earlier entry or exit signal than waiting for the price chart’s own trendline to be violated.
- Rising open interest alongside rising prices indicates that new capital (new long and new short positions) is actively entering the market to support the price move, rather than the move being driven by short-covering or position unwinding; because open interest is a futures-specific concept (tied to outstanding contracts rather than shares), this money-flow read is only meaningful in futures markets, which is why the Herrick Payoff Index is specifically designed for and applied to futures rather than equities.
- Both indicators are described as generating more frequent zero-line crossings and false signals when applied to daily data, since daily price/volume/open-interest figures are noisier and more susceptible to short-term fluctuations; weekly data compresses and smooths that noise, producing fewer but more meaningful signals — directly consistent with the book’s broader principle that longer time frames yield more reliable trend and divergence signals than shorter ones.
- After a Keltner Channel breakout signal has fired (a close beyond the plus or minus band), the 20-period EMA at the center of the channel functions as a secondary support level (in an uptrend) or resistance level (in a downtrend) for subsequent pullbacks; a trader who missed the initial breakout, or who exited the breakout position for a partial profit, can look for price to test the EMA and hold as a lower-risk secondary entry point within the same new trend.