Commodity Channel Index

COMMODITY CHANNEL INDEX

It is possible to normalize an oscillator by dividing the values by a constant divisor. In the construction of his Commodity Channel Index (CCI), Donald R. Lambert compares the current price with a moving average over a selected time span—usually 20 days. He then normalizes the oscillator values by using a divisor based on mean deviation. As a result, the CCI fluctuates in a con­stant range from +100 on the upside to -100 on the downside. Lambert recommended long positions in those markets with val­ues over +100. Markets with CCI values below -100 were candi­dates for short sales.

Itseems, however, that most chartists use CCI simply as an overbought/oversold oscillator. Used in that fashion readings over +100 are considered overbought and under -100 are oversold. While the Commodity Channel Index was originally developed for commodities, it is also used for trading stock index futures and options like the S&P 100 (OEX). Although 20 days is the common default value for CCI, the user can vary the number to adjust its sensitivity. (See Figures 10.8 and 10.9.)

Figure 10.8 A 20 day Commodity Channel Index. The original intent of this indicator was to buy moves above+100 and sell moves below-100 as shown here.

Figure 10.9 The Commodity Channel Index can be used for stock indexes like this one and can also be used like any other oscillator to measure market extremes. Notice that the CCI turns before prices at each top and bottom. The default length is 20 days.

THE RELATIVE STRENGTH INDEX (RSI)

The RSI was developed by J. Welles Wilder, Jr. and presented in his 1978 book, New Concepts in Technical Trading Systems. We're only going to cover the main points here. A reading of the original work by Wilder himself is recommended for a more in-depth treatment. Because this particular oscillator is so popular among traders, we'll use it to demonstrate most of the principles of oscil­lator analysis.

As Wilder points out, one of the two major problems in constructing a momentum line (using price differences) is the erratic movement often caused by sharp changes in the values being dropped off. A sharp advance or a decline 10 days ago (in the case of a 10 day momentum line) can cause sudden shifts in the momentum line even if the current prices show little change. Some smoothing is therefore necessary to minimize these distor­tions. The second problem is that there is the need for a constant range for comparison purposes. The RSI formula not only pro­vides the necessary smoothing, but also solves the latter problem by creating a constant vertical range of 0 to 100.

The term "relative strength," incidentally, is a misnomer and often causes confusion among those more familiar with that term as it is used in stock market analysis. Relative strength generally means a ratio line comparing two different entities. A ratio of a stock or industry group to the S&P 500 Index is one way of gauging the relative strength of different stocks or indus­try groups against one objective benchmark. We'll show you later in the book how useful relative strength or ratio analysis can be. Wilder's Relative Strength Index doesn't really measure the relative strength between different entities and, in that sense, the name is somewhat misleading. The RSI, however, does solve the problem of erratic movement and the need for a constant upper and lower boundary. The actual formula is calculated as follows:

RSI = 100 – 100/1+RS

RS = Average of x days' up closes/ Average of x days' down closes

Fourteen days are used in the calculation; 14 weeks are used for weekly charts. To find the average up value, add the total points gained on up days during the 14 days and divide that total by 14. To find the average down value, add the total number of points lost during the down days and divide that total by 14. Relative strength (RS) is then determined by dividing the up aver­age by the down average. That RS value is then inserted into the formula for RSI. The number of days can be varied by simply changing the value of x.

Wilder originally employed a 14 day period. The shorter the time period, the more sensitive the oscillator becomes and the wider its amplitude. RSI works best when its fluctuations reach the upper and lower extremes. Therefore, if the user is trading on a very short term basis and wants the oscillator swings to be more pronounced, the time period can be shortened. The time period is lengthened to make the oscillator smoother and narrower in amplitude. The amplitude in the 9 day oscillator is therefore greater than the orig­inal 14 day. While 9 and 14 day spans are the most common val­ues used, technicians experiment with other periods. Some use shorter lengths, such as 5 or 7 days, to increase the volatility of the RSI line. Others use 21 or 28 days to smooth out the RSI signals. (See Figures 10.10 and 10.11.)

Figure 10.10 The 14 day Relative Strength Index becomes overbought over 70 and oversold below 30. This chart shows the S&P 100 being oversold in October and overbought during February.

Figure 10.11 The amplitude of the RSI line can be widened by shortening the time period. Notice that the 7 day RSI reaches the outer extremes more frequently than the 14 day RSI. That makes the 7 day RSI more useful to short term traders.

Interpreting RSI

RSI is plotted on a vertical scale of 0 to 100. Movements above 70 are considered overbought, while an oversold condition would be a move under 30. Because of shifting that takes place in bull and bear markets, the 80 level usually becomes the over­bought level in bull markets and the 20 level the oversold level in bear markets.

"Failure swings," as Wilder calls them, occur when the RSI is above 70 or under 30. A top failure swing occurs when a peak in the RSI (over 70) fails to exceed a previous peak in an uptrend, fol­lowed by a downside break of a previous trough. A bottom failure swing occurs when the RSI is in a downtrend (under 30), fails to set a new low, and then proceeds to exceed a previous peak. (See Figures 10.12a-b.)

Figure 10.12a A bottom failure swing in the RSI line. The second RSI trough (point 2) is higher than the first (point 1) while it is below 30 and prices are still falling. The upside penetration of the RSI peak (point 3) signals a bottom.

Figure 10.12b A top failure swing. The second peak (2) is lower than first (1) while the RSI line is over 70 and prices are still rallying. The break by the RSI line below the middle trough (point 3) signals the top.

Divergence between the RSI and the price line, when the RSI is above 70 or below 30, is a serious warning that should be heeded. Wilder himself considers divergence "the single most indicative characteristic of the Relative Strength Index" [Wilder, p. 70],

Trendline analysis can be employed to detect changes in the trend of the RSI. Moving averages can also be used for the same purpose. (See Figure 10.13.)

Figure 10.13 Trendlines work very effectively on the RSI line. The breaking of the two RSI trendlines gave timely buy and sell signals on this chart (see arrows).

In my own personal experience with the RSI oscillator, its greatest value lies in failure swings or divergences that occur when the RSI is over 70 or under 30. Let's clarify another impor­tant point on the use of oscillators. Any strong trend, either up or down, usually produces an extreme oscillator reading before too long. In such cases, claims that a market is overbought or oversold are usually premature and can lead to an early exit from a profitable trend. In strong uptrends, overbought markets can stay overbought for some time. Just because the oscillator has moved into the upper region is not reason enough to liqui­date a long position (or, even worse, short into the strong uptrend).

The first move into the overbought or oversold region is usually just a warning. The signal to pay close attention to is the second move by the oscillator into the danger zone. If the second move fails to confirm the price move into new highs or new lows (forming a double top or bottom on the oscillator), a possible divergence exists. At that point, some defensive action can be taken to protect existing positions. If the oscillator moves in the opposite direction, breaking a previous high or low, then a diver­gence or failure swing is confirmed.

The 50 level is the RSI midpoint value, and will often act as support during pullbacks and resistance during bounces. Some traders treat RSI crossings above and below the 50 level as buying and selling signals respectively.

USING THE 70 AND 30 LINES TO GENERATE SIGNALS

Horizontal lines appear on the oscillator chart at the 70 and 30 values. Traders often use those lines to generate buy and sell sig­nals. We already know that a move under 30 warns of an over­sold condition. Suppose the trader thinks a market is about to bottom and is looking for a buying opportunity. He or she watches the oscillator dip under 30. Some type of divergence or double bottom may develop in the oscillator in that oversold region. A crossing back above the 30 line at that point is taken by many traders as a confirmation that the trend in the oscilla­tor has turned up. Accordingly, in an overbought market, a crossing back under the 70 line can often be used as a sell signal. (See Figure 10.14.)

Figure 10.14 The RSI oscillator can be used on monthly charts. Notice the two major oversold buy signals in 1974 and 1994. The overbought peaks in the RSI line did a pretty good job of pinpointing important tops in the utilities.