By Sam Seiden, Online Trading Academy Instructor
While I do not use indicators or oscillators in my own trading, I do know one thing for sure - they all work. Yes, I said they all work fine and I mean it. What is needed is to define the word "work." These are all lines plotted on a chart based on different mathematical calculations depending on the indicator or oscillator. The math works fine and the lines are plotted where they should be so do they work? YES. If the definition of "working" has to do with producing profitable buy and sell signals in a market for trading, my answer changes. Most buy and sell signals produced by indicators and oscillators don't lead to profits. If you find that your account is shrinking because of this, the likely reason is because you're attempting to create profitable buy and sell signals with these tools by number crunching the inputs. Most traders are glued to indicators and oscillators and that's fine if you use them correctly. The issue is that many traders take each conventional buy and sell signal an indicator produces and that can lead to trouble. For today's piece, I will focus on the Commodity Channel Index (CCI) simply because it's popular but rest assured, the concepts in this piece are equally applicable for any of the major indicators and oscillators. For those new to trading, the following information should provide a good foundation of an understanding of CCI and how indicators and oscillators work best with price.
CCI attempts to measure the variation of a stocks/futures price from its statistical mean. High CCI values show that prices are unusually high compared to average prices. Low CCI values show that prices are unusually low compared to average prices. The CCI is an oscillator that typically fluctuates between –100 and +100. Prices are considered overbought when CCI moves into + 100 territory. Prices are considered oversold when CCI moves into – 100 territory.
Figure 1 The CCI shows overbought and oversold levels of –100 and +100. CCI extremes correspond to turns in price as seen on the candlestick chart. The turn in price in any market is where a trader obviously wants to buy and sell. However, if trading were as easy as taking these automated buy and buy and sell signals, everyone would be making easy money, but that's not how it works. When using an oscillator like CCI (or RSI, MACD, Stochastics, and so on), it is important to take into account two things we teach and preach at Online trading Academy: Trends and Support and Resistance.
Figure 2 In an uptrend, the ideal use for CCI is to help identify low risk buying opportunities when CCI produces readings of –100 or more. The slope of the 20 ma helps show us the prevailing trend is up. The logic is that when CCI is oversold during an uptrend in price, that means someone is selling after a decline in price and in the context of an uptrend. That seller is making a mistake and the combination of trend and CCI is telling us this. So, we want to buy from this novice seller as the risk is low, reward is high, and the odds are stacked in our favor.
Figure 3 In an uptrend, the CCI can produce readings of +100 or more, but is of little use in identifying tops or potential turning points for a short entry. These readings should be ignored for entry opportunities.
Figure 4 In a downtrend, the ideal use for CCI is to help identify low risk shorting opportunities when CCI produces readings of +100 or more. The slope of 20 ma helps show us the prevailing trend is down. The logic here is the opposite. When CCI is overbought during a downtrend in price, that means someone is buying after a rally in price and in the context of a downtrend. That buyer is making a mistake and the combination of trend and CCI is telling us this. So, we want to sell to this novice buyer as the risk is low, reward is high, and the odds are stacked in our favor.
Figure 5 In a downtrend, the CCI extreme readings of +100 or greater lead us to shorting opportunities, while we ignore the extreme oversold readings when the trend is down. In a strong downtrend, all the oscillators will remain oversold, producing buy signals that can get you into real trouble if you buy when they occur.
Figure 6 After a breakout, prices had a sharp sell-off into support which was also the origin of the breakout. This was accompanied by a very extreme CCI reading of –166.67 and in the context of an uptrend, offering a very low risk / high reward buying opportunity. In this example, we are taking our trend and CCI logic and making it stronger by incorporating support (demand) and resistance (supply).
We use CCI to identify novice buying and selling in the wrong areas and at the wrong times. Proper use of the CCI (or any indicator or oscillator) in conjunction with Trend analysis and demand and supply analysis can help stack the odds in your favor when forming a trading decision and trading plan. It also helps take emotion out of trading as it allows us to view objective information at times when trading emotions are tested to the fullest. Keep it nice and simple.
Have a great day.
- Sam Seiden sseiden@tradingacademy.com
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