Stock Buy and Sell Signals With The 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.

Even the inexperienced observer is aware that stocks exhibit cyclical and trending behavior patterns. Obviously, traders want to 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 using any weighting factors that would artificially distort the raw data. For example, it uses a simple average rather than over-weighting data at one end of the measurement period (as in a weighted moving average or exponential moving average). Comparing current prices to a simple moving average also provides a moving reference point (it always reflects current conditions without biasing it). The equation for the CCI has 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. In statistics, 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. It was his opinion 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." Most indicators give an exit signal after the extreme price has been reached. The CCI, on the other hand, gives an exit signal at or before the extreme price with unusual frequency. 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 1/3 of the cycle length (the cycle length is twice the trend length). This means the ideal CCI measurement will be less than 2/3 of the trend length. For example, the standard 20-day period is 1/3 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.

Our own charts are plotted with a zero line and with horizontal lines at +100 and -100. Outside these lines we plot two others at +200 and -200 respectively. The latter are considered extreme readings. 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 our own stockdiscipline.com traders use the CCI.
1. Buy when the line moves above -100 from below (at "F" in the chart) and sell when it drops below +100 (at "E") or any time it rises above +200. If it does rise above +200, some traders prefer to wait until it drops below that level to sell.
2. Buy whenever the line crosses below -200 or wait until it crosses back above -200. Sell when it crosses from above to below +100.
3. Sell or buy when it crosses an uptrend line or downtrend line respectively. Traders use trendline and pattern analysis on a CCI chart, just as they would on a stock chart.
4. Buy when the CCI bounces off of the zero line. When the CCI reaches the zero line, the stock's average price is at the moving average used in computing the CCI. Therefore, a bounce off the 20-day CCI zero line occurs when the stock bounces off its own 20-day moving average (that is, the moving average of its daily average price). This is often considered to be a good time to buy because the stock has not only pulled back to its short-term support (providing a relatively low entry price) but it has also reaffirmed its upward trend by bouncing off the average.

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. 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. 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. Compare the signals generated by the CCI (trendline penetrations, head-and-shoulder neckline penetrations, and other signals) with the price action of the stock at those signal points. The CCI can be uncannily predictive.

The indicator is not perfect. No indicator is, but there are ways to address those shortcomings. False buy signals, for example, 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 or -100 line after the crossover. If after crossing above the -100 line the CCI line comes back to -100, reverses, and continues upward, the buy signal could be considered to have been given when it bounced off the -100 line. 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 plunging 20-day average, for example, would be a good reason for 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.

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.

Copyright 2008, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com

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