Cooking Tools #3: Using the CCI as a Timing Indicator

Probably the most important decision regarding trading stocks is when to get into a trade and when to get out of it. Traders use many technical indicators to determine this. The more popular devices are moving averages, support and resistance levels, price patterns, and candlestick chart patterns. (Price patterns and candlesticks were the subject of Cooking Tools #1 & #2.) Today we'll be looking at another tool to add to your arsenal of timing tools: the CCI which is short for the Commodity Channel Index.

The CCI was developed by Donald Lambert who introduced it in an article in the October 1980 issue of Commodities magazine (now Futures). It has since grown in popularity and is used by traders to identify cyclic trends not only in commodities, but in equities and currencies as well. Although it works best in cyclic markets, it can be also be used in trending ones too as we'll see shortly.

What is the CCI?
The CCI is an oscillator and like most oscillators it is used to identify overbought and oversold conditions. It does this by measuring the relation between price and the mean deviations from a specified moving average:

CCI = (Price - Moving Average)/(0.015 x Mean Deviation)

Essentially, the CCI measures how far away price is from the moving average and how fast it moved to get there. If the price is right at the moving average, the CCI value will be at zero. The constant (0.015) is used in the above equation as normalizing factor. It restricts about 80% of the values to be between -100 and +100. The theory here is that when the CCI goes way outside either of those two boundaries, the stock is either oversold or overbought.

Most advanced charting services offer the CCI. On a chart, it is commonly represented by a series of bars that are centered around a zero point. (See chart below) The trick to setting up the CCI is in the choice of moving average. Lambert suggests using 1/3 of a price cycle where a price cycle is defined as the number of days (or other time unit) between successive price highs or lows. For example, if a stock makes a low about every 90 days, then a 30 day moving average is used. From my experience, however, sometimes you need to play around with it to get the best fitting moving average. Be aware that sometimes the stock will change its cyclic rhythm, so what time interval has worked in the past may not work as well in the future. (Note that most charting services use a moving average of 20 as the default.) The following is a weekly chart of the S&P 500 comparing a CCI with a 57 day moving average (which I derived from using price lows) with a CCI with a 20 day moving average.

How to interpret the CCI
There are two ways to interpret this oscillator--one as a straight indicator and the other as a divergence indicator. There are many ways that this can be used as a straight indicator. One way is to go long when the CCI rises back above the -100 level and to sell when it drops below the +100 level. However, this can lead to a lot of whip-sawing. A better way is to go long when the CCI crosses into positive territory (above zero) and exit the long position when it falls below zero. I like to wait a day or two on either side for confirmation before entering or exiting a position. You can see from the above chart that if you were long the S&P, the CCI(57) would have kept you long until this past January when it finally dropped below zero for two weeks.

But the divergence in the CCI for the months preceding the drop would have clued you in to the fact that the market was heading for a reversal. This is the other way to use the indicator. If the stock is making new highs but the CCI isn't, the two are said to be divergent and a price reversal is on the horizon.

Another way to identify when a stock is greatly overbought or oversold is to look at the magnitude of the CCI. Extreme values--over +300 or under -300--signal that a stock has moved way beyond its moving average making a correction highly likely. This “tell” is especially useful if you have a short position. Any move off an extremely negative CCI number is a signal to cover.

Day traders will find the CCI to be a useful entry and exit tool, too, especially if several time-frames are viewed simultaneously. I used this method along with other indicators to daytrade the S&P Emini futures. It took me a month to get the hang of it, but it eventually worked out very well (although it burned me out!).

Because it's an oscillator, the CCI used by itself works best in sideways markets; in trending markets the CCI alone will lead to false buy and sell signals. This is when you need to loosen your interpretation of the indicator and only pay real attention to it when it crosses the zero line. Other indicators (like the ones mentioned at the top) used in conjuction with the CCI will help you to winnow the false signals from the real ones.

This has been a brief introduction to the CCI and by no means is it meant to be definitive. There are plenty of books on technical analysis that have expanded descriptions and uses of this indicator. Online, check out Woodie's CCI club which contains a lot of info on trading with the CCI. (www.woodiescciclub.com)