Commodity Channel Index (CCI)
Stocks and commodities cycle. The Commodity Channel Index (CCI) was created by Don Lambert. It is used to detect when cycles begin and end. Thus, it has been widely used as a buy and sell signal generator for both stocks and commodities.. [There are other buy and sell signal systems on this site (moving average crossover systems price and volume surges, and so on). There are also illustrations of stock "setup" patterns and "trigger events.."]
Even the inexperienced observer is aware that stocks exhibit cyclical and trending behavior patterns. The problem for traders is detecting when these movements begin and end. Traders profit most when they can buy early when a stock begins to trend and sell early when that trend comes to an end. The CCI can be a great help in spotting these trend changes. It examines current prices in the light of past prices without artificially distorting the raw data. For example, it uses a simple average rather than over-weighting data at one end of the measurement period. Comparing current prices to a simple moving average also provides a moving reference point (it always reflects current conditions). The equation for the CCI uses a divisor that adjusts to reflect price variability. This divisor is smaller when the stock is non-trending (when the stock exhibits less variability) and larger when a breakout occurs (when the stock exhibits large variability). Thus, it reflects both prices and patterns of price fluctuation. Statistically, such numbers are called "measurements of variability."
The "current price" is not the closing price but the average of the high, low, and close. The divisor (or "measurement of variability") is the average amount by which the "current price" deviates from the moving average of the "current price" during the period of measurement. The CCI computation is scaled so that 70% to 80% of the random fluctuations fall between –100 and +100.
When Don Lambert developed the CCI, tests were performed for the 5-, 10- 15- and 20-day periods of measurement. He found that although shorter periods like the 10-day CCI detected tops well for a variety of trend lengths, it was not as good at detecting "breakouts." Also, a surprising characteristic of the indicator is the frequency with which it gives an exit signal at or before the extreme price rather than after the extreme price as with other indicators. To avoid the excessive whipsawing likely with shorter periods of measurement, Lambert settled on 20 days as the standard period of measurement. However, traders are encouraged to experiment to discover the period that works best for them. Many traders prefer to use 14 days and some prefer to use a combination of periods. Lambert suggests that the period chosen should be less than ⅓ of the cycle length (the cycle length is twice the trend length). This means the ideal CCI measurement will be less than ⅔ of the trend length. For example, the standard 20-day period is ⅓ of a 60-day cycle, and the 60-day cycle has a 30-day uptrend and a 30-day downtrend. Therefore, the 20-day period is most efficient for trends of more than 30 days. You must determine for yourself the trend duration for which you want to optimize the CCI. We plot the 20-day CCI.
Our chart shows horizontal lines at +100 and –100 and outside these lines are two others at +200 and –200 respectively. We consider the latter to be extreme readings. The zero line is marked by the arrow at "H." The rules for trading with the CCI were originally designed for short-term commodity traders. When the CCI crossed above the +100 line it was a buy signal. When it fell below that line it was a sell signal. Similarly, a short sale would be entered when the CCI crossed below -100 and it would be closed out when the CCI crossed above –100. The thinking was that these regions represented occasions when momentum was relatively high and when small profits could be captured in a few days. Since the CCI was originally formulated, other ways of using it have been found. Here are some of the ways it is used.
Chart patterns normally associated with price data have the same implications when they are found in CCI charts. For example, the head-and-shoulders top consists of 3 highs with the center high greater than the highs on either side. The head-and-shoulders bottom consists of 3 lows with the center low below the lows on either side. Look at the small "head-and-shoulders" pattern at "O." The short line ending at "O" is called the neckline. When the price of a stock crosses below such a line on a price chart, it is considered a sell signal. The same is true when this happens on a CCI chart (notice how the stock dropped when the crossover occurred on the CCI. Likewise, an upside-down or inverted head-and-shoulders pattern can give a buy signal. A crossover of the neckline of an inverted head-and-shoulders pattern on the CCI would be the triggering event. Check each place where there is an arrow in the CCI chart and compare the location of that arrow with the price action of the stock that follows. Comparing the CCI to the chart of the stock and analyzing the pattern of the CCI in conjunction with the pattern of the stock can give remarkable insight into the stock’s behavior and greatly help in the timing of purchases and sales. The CCI can be uncannily predictive.
The indicator is not perfect. No indicator is. Before the buy signal at "F" there were two false buy signals. These can be addressed by waiting for a greater move above the line, by waiting a day or two to see if the CCI reverses, or by waiting for the "rejection" from (or "bounce" off of) the –100 line after the crossover. For example, after crossing above the –100 line at "F", the CCI line came back to –100, reversed, and continued upward. The buy signal would be given when it bounced off the –100 line (look directly above the letter "F"). The same series of events can be seen in August. Here, too, there were two false signals. After the second crossover, the CCI line returned to the –100 line and "bounced" off to resume its climb. Since the "bounce effect" does not always occur, it is well to remember that the CCI can be used in combination with other indicators and in conjunction with an analysis of the price pattern itself. The CCI crossing above the –100 line while the stock price hits a savagely declining 20-day average, for example, might cause a trader to wait and see what happens. That 20-day average represents resistance. The odds are that the stock will bounce off the average and decline again. On the other hand, if the 20-day moving average is slowing down in its descent or leveling off, the stock could very well penetrate it.
Finally, the trader might consider another option. That is, to simply go elsewhere if all your conditions for a purchase are not satisfied or if you are uneasy about the signals you are getting. That’s why it’s good to always have several purchase candidates. It allows the trader to say, "if you do not meet all my conditions for a purchase, I’ll wait for a stock that does." Sometimes, it is far better to simply walk away and wait for a better candidate to come along. It’s almost certain that you won’t have to wait long.
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Dr. Winton Felt maintains a variety of free tutorials, stock alerts, and scanner results at www.stockdisciplines.com has a market review page at www.stockdisciplines.com/market-review has information and illustrations pertaining to pre-surge "setups" at www.stockdisciplines.com/stock-alerts and information and videos about volatility-adjusted stop losses at www.stockdisciplines.com/stop-losses
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