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QUAD CCI – CHALLENGING THE TRADITIONAL VOLATILITY PARADIGM
Chapter Excerpt from Volatility Illuminated by Mark Whistler
Within Forex, there's a term professional traders often throw around when referencing the retail community… Retail traders are frequently cited as doing nothing more than just 'chasing indicators'. Sadly, so many retail traders fall victim to the mindset of believing trading is easy and/or if they just uncover the 'secret technical code', they will never lose again. With this mindset, it's no wonder these same traders unfortunately constantly find themselves on the wrong side of the eight ball when volatility kicks in. However, there is another way to trade...
Throughout Chapter Six, traders will gain more insight into how and why 'chasing indicators' is such a losing game, while also seeing how traders can begin putting indicators back on their side…to overcome destructive volatility that overwhelms most of the retail community daily.
However, it is important to remember that while the Quad CCI strategy you're about to read about is something I personally use, I overlap the strategy with volatility and probability, WVAV and WAVE • Price Mass to gain greater insight into whether the signals produced are real- or are really just 'those old charts fibbing' - yet again.
While the discussion on multiple CCI time periods is certainly not a "one stop shop" to completely navigate the larger universe of trading stocks, futures, commodities and Forex, using the indicator correctly can definitely assist traders when markets are offering little guidance.
Take a look at the below hourly chart of the EUR/USD, which shows the basic 'feel' of the Commodity Channel Index (CCI), at least, as most traders use the indicator.
For the most part, the indicator is used to look for reversal (or trend re-entry points) when the indicators falls from above +100 back under +100, or up from underneath -100, above -100. What you will hopefully notice right away is the first 'sell' signal (from the left) and the third buy (also from the left, which I've marked with an asterisk '*'), both provided false signals. Figure 6.1
To understand why the false signals could be appearing, we need to take a closer look at the indicator overall… According to one major Website, (I'm keeping their name anonymous to not drag them through the dirt, though I have notified them of the error):
"An oscillator used in technical analysis to help determine when an investment vehicle has been overbought and oversold. The Commodity Channel Index, first developed by Donald Lambert, quantifies the relationship between the asset's price, a moving average (MA) of the asset's price, and normal deviations (D) from that average. It is computed with the following formula…"
Here's where we begin to split hairs on a few important matters that I believe you should be aware of… The Website is correct that CCI was developed by Lambert (in 1980, FYI), moreover, the definition is also correct in that the indicator is meant to help determine overbought and oversold areas… However, CCI was also developed to help find 'cyclical swings' of commodities and other financial instruments. What's more, in the above definition, you will notice the use of the terminology 'normal deviation.'
Just to make sure I'm not completely losing my mind, I checked about twenty different Websites for definitions of CCI while writing this and what I've found is that almost all mislead readers using the same, or similar terminology…setting you up for failure.
The problem is likely because most of the information on trading-related Websites is written by people who don't really trade in real life…they don't even know the stuff they are regurgitating is wrong.
I like to think of the situation similar to a rocket scientist explaining how to smooth drywall mud almost perfectly…in one shot. Though the task might seem easy overall, unless you've actually done it a few times, there's no way you'd know the tricks of the trade, or the 'inner workings' of how drywall mud sets on the wall and in the bucket, or even how important the 'art' of trowelling is. (I learned the hard way renovating a house many years ago… For the rest of my life, I will have an immense amount of respect for drywallers. And let me tell you, I mean it too!)
Back on subject, in most definitions of CCI, we often hear terms like normal deviation, or standard deviation as part of the equation. However, what we must understand…is that CCI is calculated using mean deviation (or mean absolute deviation MAD), not standard deviation.
Moreover, there is no such thing as 'normal deviation.' (Just to split hairs, Roget's 21st Century Thesaurus, Third Edition lists 'normal deviation' as a synonym for standard deviation; however, standard deviation is not used calculating CCI, mean deviation is.)
Furthermore, what the heck is 'overbought' and 'oversold'? As you're about to see, when CCI is trading above +100 and below -100, whatever financial instrument the indicator is measuring may not be overbought, or oversold at all… I'm not kidding, the stuff many Websites feed traders can be just plain damaging...
To dig into the specifics, CCI is calculated using the 'mean deviation', which is thought of as providing greater accuracy to non-normal (non-Gaussian) data than the more commonly used standard deviation. In the paper Revisiting a 90-year-old debate: the advantages of the mean deviation by Stephen Gorard (presented at the British Educational Research Association Annual Conference, University of Manchester in 2004), the author asserts, "In those rare situations in which we obtain full response from a random sample with no measurement error and wish to estimate, using the dispersion in our sample, the dispersion in a perfect Gaussian population, then the standard deviation has been shown to be a more stable indicator of its equivalent in the population than the mean deviation has. Note that we can only calculate this via simulation, since in real-life research we would not know the actual population figure, else we would not be trying to estimate it via a sample."
I understand why mean deviation is used in CCI (to attempt to compensate for non-synthetic, non-perfect Gaussian price data); however, after spending much of the past year mapping distributions in markets, I would argue the shorter the timeframe measured, the more 'bell shaped' data becomes.
What I'm saying is perhaps the formula for CCI is more accurate with a greater set of data and that perhaps on shorter timeframes, the formula needs to be changed to utilize standard deviation, over mean deviation. Don't worry though, we will change the formula on your charts, without actually changing the formula at all! I'll explain in just a moment… Below is the formula for CCI, please don't worry about digging too deep into the math… You don't have to crunch the numbers, I would just like for you to understand 'the philosophy' of what's happening, over the mathematical fun-o-rama calculator super-time. The philosophy is what matters…
CCI is calculated as:
CCI = (TPn - TPSMAn) / (MD * 0.015)
Where TPn = Typical Price (High + Low + Close)/3
TPMA = SMAn = [(TP1 + TP2 + TP3…+TPn)/n]
Then...
CCI = [[TP current period – TPMA current period]
Divided by
[((TP1 – TPMA1) + (TP2 – TPMA2) +…TPn + TPMAn))/n]]
All multiplied by 0.015
Okay, so where the heck is all of this going? The whole point of CCI is really to measure the major 'Containment Zone' of a commodity, stock, currency, or whatever… However, like everything else in the market that's totally misleading and confusing, for whatever reason, the whole point of CCI (as explained by 90% of the Websites out there) is as well.
Definitions of CCI state 'cyclical swings', major price movements and reversals, deviation this and that…yada, yada, yada...
Here's what's really happening...
Imagine a teeter-totter that has values from -500 to +500, with zero being the middle. I place a bowling ball on the teeter-totter and get it rolling to the right side towards +500 and then tell you that you can't let the ball roll off the end, but the rules are you can only touch the teeter-totter and not the ball itself, what would you do? Most likely, you would move to our left and push down on the opposite side of the teeter-totter (the -500 side) to get the back rolling back towards the middle.
Now, imagine that I had drawn -100 and +100 on either side of 0 (zero), which right now, because you are pushing down on -500, the ball is rolling back towards.
It would make sense that when the ball is rolling back from the +500
area and crosses over +100 towards the 0 (zero), the ball would
likely cross zero right? Right?
Right...
However, please also imagine that I've drawn the numbers slightly awkward to common sense in that the further from zero we get (conversely, the closer to -500 and +500 the ball is), the more densely I've drawn the numbers grouped together… As a picture tells a thousand words, I've drawn the teeter-totter for you, as a bit of a visual aid. Please see Figure 6.1 on the following page and please excuse my art… The main point is via Chebyshev's Theorem in statistics, we know that (on average), about 75% all data will rest within two standard deviations of the mean. (In the case of a normal Gaussian curve, the probability is actually nearly 95% of all data should sit within two standard deviations of the mean, thus, in using mean deviation, Lambert was likely attempting to accommodate for non-perfect bell-shaped data. Moreover, Lambert was likely also using Chebyshev's Theorem to justify the containment range of -100 and +100, implying 70% to 80% of all data, which is why he used 0.015 as the multiplier…)
Just FYI Chebyshev's Theorem states:
"The proportion of any set of data lying with K standard deviation of the mean is always at least 1-1/K2, where K is any positive number greater than 1. For K=2 and K=3, we get the following results: At least 3/4 (or 75%) of all values lie within 2 standard deviations of the mean. At least 8/9 (or 89%) of all values lie within 3 standard deviations of the mean."
Figure 6.2
Also, please note that in the real CCI, -500 and +500 are NOT the final outlier values the indicator can move to… Theoretically, CCI could travel infinitely up, or down… However, on a common sense basis, people don't have to buy, but they do have to sell sometime, and thus, prices (and CCI) will never travel infinitely in one direction. The basic point here is that when CCI crosses back under +100, or back above -100, the theoretical underpinning is prices are moving back into a more 'normal range' after just having witnessed a period of extreme activity. What we're looking at is really just a measurement of 70% to 80% of the expected statistical range for whatever time period we're gauging … You might not be jumping up and down in your seat right now, but wait a moment and I think you could be… Though the above sounds both simple and boring, I like to think of anything that could make hordes of money…as the exact opposite… Amazingly, I would bet (without too much trouble) about 99% of all retail Forex traders don't ever even know what they're looking at when they use CCI to trade with… No wonder they have such a difficult time making money with the indicator! Honestly, by simply reading these pages, you're in the 1% elite who actually know what they're looking at when they are trading with CCI...
So what we know is this… CCI is NOT indicating overbought or oversold whenever the indicator moves above +100, or below -100. Instead, CCI attempts to measure illuminate the 'Containment Zone', which is intended to be 70% to 80% of the total range. Again, the 'Containment Zone' is denoted as the area in-between -100 and +100 in the oscillator. What I'm saying is this… In theory, when CCI is trading above +100, the stock, currency, commodity, or whatever is thought to be trading towards the top of the larger, typical range, and is in essence trading at, or above +1.2 to +1.5 standard deviations (using the term 'standard deviations' merely for the sake of example, knowing standard deviations are not used in the actual calculation of the indicator.)
Conversely, when CCI is trading below -100, we generally assume the financial instrument measured is trading below the larger, normal range and is experiencing a period of volatility, denoted most often a sharp or prolonged selloff. Here's where CCI gets very interesting for those who understand what they're looking at...
On the below chart (and I apologize for the likely confusion- it was difficult to get everything in the image even remotely clearly) you will notice what looks like fire, or hair, or something growing from the left side...
What the mysterious wig-looking thing truly is showing…is an actual representation of the 'distribution' of the price data on the chart. What we've done is literally –visually mapped- the distribution of data, so that you can see the distribution unfolding through trading action...
Here's what readers MUST make clear in their minds: What we are really looking at when we look at any price data…is data. The data is forming one HUGE distribution over all time, or a series of subset distributions, on smaller timeframes.
Notice there is outlying data towards the upper and lower end of the distributions; however, the bulk of the data rests in the middle; hence the higher mountain-like 'peak thing' towards the center.
What you are seeing is –in essence- the Central Limit Theorem in action. In statistics, the Central Limit Theorem says if we pluck a small subset of data out of a larger skewed range (the totality of market data is skewed, since time is skewwy skewness in itself), the subset should –for the most part- retain a Gaussian bell curve like shape. What you are seeing on the chart is exactly the case in point. For those who are interested, in the final chapter of Volatility Illuminated, I will discuss subset distributions further (which are really amazing and complex animals in markets); reserving the 'mega-in-depth-conversation' for last. (In reference to my own 'best for last' hype just deployed – and if you remember Chapter One, I have a 50,000 mega-fog-mouth-lamp too! Just kidding. Anyway, the topic of distributions exposes Poisson distributions as a regular facet of markets as well, thus, given the extent of the discussion required, I will hold off on the exchange until the end of the book.)
Now, taking a look at Figure 6.3 (below) we are able to easily identify that –indeed- trading action is -data- forming distributions. It is vital to 'show' the distributions, so that readers visually perceive why understanding (at the very least) the conceptual framework behind descriptive statistics is so important in day-to-day trading. The bottom line is to be better traders -on the whole- we absolutely must understand that the action unfolding on our charts is really nothing more than: data.
Moreover, as you're also about to see, CCI is really an attempt a measuring 'mean reversion' and or 'divergence' of the data. Divergence is fancy-talk for 'trending', 'moving outside of the Containment Zone', or 'geez Zeb, lookie that thang go.'
I personally think the below chart (Figure 6.3) has many, many implications within trading and volatility; which I hope you will see too.
Figure 6.3
Please take a moment to notice the lower oscillator, where I have attempted to draw lines from the actual CCI 'convergence points' at +100 and -100 (meaning the points at +100 and -100 where CCI breaks from outside the containment area…back within) up to corresponding squiggly lines in the actual chart itself.
Though my connecting lines (from CCI to the squiggly lines on the chart) are not straight, a vertical line drawn on each would connect the points. What you will notice is the CCI convergence points line up almost precisely with the USD/JPY turning back into the middle range (upwards and downwards) of the channel looking thing that is overlapping the actual price action on the chart.
What are the channel lines on the actual chart and how is it that they (almost precisely!) identify the same mean-convergence type of action as CCI?
Believe it or not [insert dramatic pause] I've drawn Bollinger Bands on the USD/JPY chart as well. However, what so many traders don't understand is that Bollinger Bands are really a visual display of potential distribution wingspan- as denoted through the visual mapping of standard deviations. (I will discuss Bollinger Bands -in detail- in the second half of the book, just FYI.) Sadly though, so many retail traders never even change the input variables (standard deviations) within Bollinger Bands, while also failing to even understand what the indicator is presenting in the first place.
Bollinger Bands come preloaded in every charting package (on the face of the planet) at two standard deviations, which most traders never even think to change...
However, in my humble opinion, to truly unlock the 'power' of standard deviations as a measurement of volatility and probability within trading, we must change the pre-loaded default variables. Again, I will discuss standard deviations in great length in Part Two of Volatility Illuminated.
Anyway, I have changed the values in the below bands to 1.25 standard deviations… By doing so, I'm measuring just over 70% of the total potential 'containment' of the distribution at hand. Does what I've just mentioned sound a little like CCI?
It should, because we're basically looking at the same thing; however, CCI is calculated with mean deviation (or [MAD] for Mean Absolute Deviation), while Bollinger Bands are calculated using standard deviation. Overall, yes I had to tweak the standard deviations setting in the Bollinger Bands slightly, but really, the two are one in the same. (FYI, just in case you might be wondering, the Bollinger Bands are measuring 14-periods of data, just as CCI in the chart.)
Here's where the story gets even better… Have you ever had trouble identifying trend? Or, have you taken a position that suddenly goes against you and you look back and say, 'ohmygosh that was ridiculous, what was I thinking?!' If you've ever been in this place of brilliant trading euphoria, what I'm about to present could help tons. See, when looking at shorter-term periods, many traders often mistakenly take a position against the longer-term trend, based on CCI reversing down from the +100-oscillator level, or up from below the -100-oscillator level and thus, find themselves in big trouble when the longer-term trend resumes.
And really, I understand why they're making this mistake…after all, if they had learned about CCI through just about any trading related Website on the Internet, they would think above +100 is overbought and below -100 is oversold. Really though, above +100 means "moving above the first standard deviation", while -100 means "moving below the first standard deviation", both of which mean, "subset distribution on the move – alert – alert!"
So how do we defeat this potentially misleading and costly pitfall? We identify trend.
Note: Please always remember to walk down through all your chart timeframes (macro to micro) from monthly to weekly to daily to 4-hour to hourly to 30-minute to 15-minute to 10-minute and so forth… Walking down through the charts is the best way to identify trend from the wide-scope monthly all the way into the minutia of the minute. Again, we're simply attempting to keep the forest in our mind's eye, when we're in the trees. Specifically to identify trend though, please look at the below 4-hour chart of the EUR/USD… I have added in 1.25 14-period standard deviations with 14-period CCI. What I think you will notice is that when the EUR/USD is traveling near the mean, we're basically 'trendless.'
What's more, in those peculiar times when CCI is actually trading below -100, it is precisely when the EUR/USD was staging the largest and fiercest moves downward...
Conversely, just when the EUR/USD traded to the top of the 'Containment Zone', we failed. But how many people would have known to associate the move downward below -100 in CCI as 'big selloff to come'?
Figure 6.4
What's more, how many would have known to spot the 'failure coming' at the top of the range as well? I can assure you not many...
Here's why...
Because we're taught to use CCI as a tool for reversals, or trend-reentry (still a type of reversal) we're not taught that the breach of -100 and +100 actually means the stock, currency, commodity, or whatever is really headed towards, or trading outside of the first standard deviation, which is exactly when and where the steepest moves occur. We're taught to look for CCI to cross back into the middle from above +100, or below -100.
I would like to argue; however, some of the best trades are waiting for CCI to slip outside of +100 and -100 and then trading 'with the trend' or with momentum, or 'volatility'. Then, when CCI comes back across +100 and -100 (after we've participated in the trending move), we can close our positions and let the 'containment-area trendless chop-chop traders' slug it out.
On the top of the range, you will also quickly notice that we were already in a descending trend when the EUR/USD was trying to make new highs… But really, the EUR/USD wasn't making new highs, it was just trading to the top of the Containment Zone in an already descending trend, which is also likely, one of the best places to enter 'with the trend' for those who just love those mean reversion 'CCI crossing back towards zero' types of positions. I don't know about you though, but there's nothing I hate more than getting stuck in choppy lateral trading, so often, I look for the breakout, or breakdown from the Containment Zone, after (and only after) an identifiable trend is in place. Okay… we should now see that at times, identifying trend (with CCI) can be almost as easy as simply adding 1.25 standard deviations to our charts and keeping an eye on BOTH CCI and the Containment Zone. Why is it called the Containment Zone?
Because I just made it up… Okay, other than that, unless you have some insight into fundamentals, volatility/probability, order flow, or hopefully another technical analysis magic trick, the only thing you get in the Containment Zone is a date with Mean Joe Green...
Where the 'mean' sits…is where the 'bulk' of our data should sit. The 'Containment Zone' is statistically (if we're measuring 1-standard deviation on either side of the mean) where approximately 70% of the data should reside. And in the case of the 1.25 standard deviations, we're really looking at a little over 70%.
What I'm saying is if you're taking a position at, or near the mean, without having a really good reason for doing so, the position could just as easily reverse against you, as work in your favor. If you're on the mean, you're on the hill, on the top of the triangle, at 50/50…tossing your cash into the mystical Forex roulette wheel.
As I just stepped away from my screens for a cup of coffee… I realized that perhaps I'm being a little harsh on old Mean Joe Green… There are actually times when we can take a step into Green's house and walk away unscathed… With the aforementioned in mind, we'll take a few moments to show how we can take positions into the mean, while also using CCI in a more traditional fashion. However, we're not going to use the 'same old' one-line in an oscillator trick… Just to be on the safe-side, we're going to overlay four CCI's to form the 'Quad CCI Strategy.' Does this thing sound like a wicked new Bic® Razor, or what?
Standard Stan And The Four Horsemen
When I first started writing about CCI a few years ago, there were only two… Somehow, the dynamic duo grew into 'The Four Horsemen'. I guess if I write a sequel to this book in a few years, there might be two more… Maybe I'll call it: Six Pack CCI.
Yes, I know I'm not funny.
Jumping right in, over the following pages we will learn how to use CCI to identify trend…to defeat false CCI signals, while also attempting to time positions 'with the trend' both inside and outside the Containment Zone. All of which can be efficiently accomplished by applying two four CCI time periods to the same chart. Our goals in doing so are to:
1. Prevent ourselves from taking positions against momentum. 2. Time our trades with short-term 'wrist-rocket' thrust from the larger market momentum. 3. Clearly determine whether the trend is up, down, or sideways.
Foremost please note that I have provided MetaTrader code for 'two CCI' at the end of the book, while having also made the code available on www.WallStreetRockStar.com and fxVolatility.com.
After the code is copied into your MetaEditor / MetaTrader Indicator folder, you should be ready to go. Also, please note that if you do not have MetaTrader, you can simply stack four CCI indicators windows in one of the various free charting applications available on the Internet. For those who use the popular charting Website Stockcharts.com, you will only be able to stack three CCI's one above and below the chart and one in the actual chart window… I've already prepared a chart for you and you can access it at:
http://stockcharts.com/h-sc/ui?s=$INDU&p=D&b=5&g=0&id=p53666348969
Moreover the code I am supplying only contains two CCI's in one widow, this is to prevent excess confusion with too much happening in one oscillator window. To see all four CCI, please stack two windows, as you will see I have done in the examples throughout the remainder of the chapter.
If you are using MetaTrader (it's free, by the way… [and] some brokerage demo accounts [United World Capital, for example] will allow tracking stocks and commodities too), after you have placed the files in your Indicator folder, please close and reopen MetaTrader. Assuming the file is in the right folder, the indicator will show up in your "custom indicator" drop down menu within your charts. Add the Two CCI code twice, using 14 and 100-periods in the top window and 50 and 200-periods in the lower window.
Standard Sam, the Deviation Man will help keep The Four Horsemen in check as the trading day rolls out… To see Standard Sam, please add a 50-period Bollinger Band(s) to your chart, set at 1.25 Standard Deviations (STD). Also, as you have likely noticed, I am using a chart of IBM (NYSE: IBM) to show that the quad CCI strategy (really though, all of the strategies in this book) work with stocks, futures, and commodities too.
Figure 6.5
As you can see, in the lower two windows, the 100-period and 200-period CCI's are denoted in the thicker black lines, while the 14-period and the 50-period are shown as the thinner in each window.
Then, on the actual price portion of the chart, you can see that I have drawn the 50-period moving average and two 1.125 standard deviations, which as you likely already have guessed, should line up with the 50-period CCI as the casing of the 'Containment Zone'.
Readers should immediately notice that the two thicker CCI lines (the 200-period CCI and the 100-period CCI in separate windows) are both traveling above zero.
Plain Jane, the trend is up. Here's what I would like to mention for newer traders… If you're having trouble deciphering trend direction, drop in quad CCI on an hourly or 4-hour chart …. If the two longer-term CCI's (200 and 100) are above 0, common sense tells us there's more bullish momentum, than bearish and vice versa for below zero. While this may sound simple, don't scoff, I know plenty of 'tenured traders' who jump at every volatility spike, like it's a massive trend change… However, it takes more than a quick 'spike' to move the 200 and 100-CCI's above, or below the zero line, thus the resilience of the indicator within itself, can be a great buffer for 'on edge' nerves, analysis paralysis, and/or muddled vision for whatever reason.
Looking at the below chart...
Figure 6.6
Traders seeking to take a position 'with the trend' can attempt to purchase pullbacks on the mean (yes, Mean Joe Green) if: 1. Longer-term CCI (at least the 200 and 100) are above zero... 2. The 50-period CCI is not below -100. 3. Common sense seems inline.
What you will notice is that if we time our long-entry when the 14-period travels back up from underneath the -100 area, we are using the shorter-term indicator as a sort of 'wrist rocket' to step in just at the right time when momentum is seemingly in our favor. What's more, by taking a position on the mean (while timing such with a 14-period pop back up into the Containment Zone) we have also given ourselves a clear stop loss point, should the market fall apart. We simply place our stops on the opposite side of the mean, knowing a breach will likely have the pair testing the lower end of the Containment Zone...
Please remember: The first loss is always the best loss.
Anyway, should the pair pop up into Standard Stan in the 1.25 area… Once we're above the standard deviation level, we can actually use the visual identification of the 'Containment Zone' as our stop to ensure we exit the trade profitably… Thus, savvy traders needed to only wait until the 14-period CCI 'reloaded' and crossed (the trigger) back above the -100 oscillator containment area reentry point to implement long positions. What we 're really doing here is using The Four Horsemen to guide our way...
The 100 and 200 are like big burly swordsmen, which are hard to budge without significant force. The 50-period CCI is more like the guy who's fast on his feet, but still tough enough to take on the big dudes… And the 14-period is similar to the scout of the party...
The fastest of the bunch, but also the first to turn-tail at any sign of danger… Basically, when we see the 100 and 200-CCI stay above the 0-line, we can infer there really isn't any reason for them to move out of their range… The 50-period CCI will sometimes venture over the 0-line, before the hefty battlers, just mentioned… However, the 14-period will often venture (quickly) way out into the yonder…and he will always return to tell his pals what he's found. Crossing back over the 100-line, traders can take 'rocket trend reentry' positions (usually on the median); however, we still want to keep an eye on the flighty 14-period CCI character… If he crosses back over the +100 or -100 level he was just scouting, it means the larger weighted CCI lines could soon to follow too, as the whole bunch runs from larger momentum on the way...
Just to mention the opposite situation from what we covered in the two charts above, if the 100-Period CCI were trading below the 0-baseline (meaning the stock, currency, or commodity is likely trading right at the 100-period moving average (mean) as well) and the 14-period CCI spiked above the +100 oscillator level, the trader could look for a short entry, assuming the 100-period CCI had not begun ascending (attacking the 0-baseline), at the same time. I'd like to mention that aggressively taking positions before CCI lines actually breach the +100/-100 oscillator levels, falling/rising from upper/lower extreme ends of the indicator window is extremely dangerous. Moreover, as the 1.25 standard deviation representation on the chart shows, movement above +100 and below -100 could indicate a larger spike of momentum to come.
With all of the aforementioned in mind, we will now look at one final aspect of CCI – Identifying Reversals.
Identifying POTENTIAL Reversals with CCI
Identifying reversals can be slightly trickier than timing 'with the trend' positions, as anytime we are trying to take a larger contrarian position against the trend, we are truly fighting momentum. However, as in life, all things eventually -always- come to an end, trends eventually…stall…and cease too. Thus, to spot potential larger reversals at hand, we will use the +100 and -100 Containment Zone lines (again), applying the 100-period CCI; however, unlike the above example, we will only use one CCI window, instead of two. What's more, in our single CCI window, we will also draw a 21-period CCI, leaving the 50-period and 200-period CCI's out. I'm making this change for two reasons:
1. At times, we must 'switch up' the lens, which we're observing the market from, especially if we are not seeing markets clearly. Figure 6.7
2. Using the 21-period gives us a sort of 'middle ground' between the jittery trading action of the 14-period CCI and the more stagnate movement of the 50-period CCI. Basically, if your intuition is telling you a reversal might be on the horizon, but you are not able to see any real signs of such within news, fundamentals, or your charts…you can always switch-up timeframes, or indicators (if even momentarily) just to turn over a few more stones.
We're actually going to use the longer-term 100-period CCI line as inference and confirmation of a potential downside and/or upside reversal, even though the line may be trading above (in the case of a bull trend), or below (in the case of a bear trend) the +100 or -100 Containment Zone lines… I'm not really a big fan of using the 100-period (or even the 50-period) as an indicator of reversal, through mean convergence from outside the Containment Zone… However, because what I'm now discussing is the 'usual' way CCI is used, I must mention it. Please keep in mind, that when we attempt to identify a reversal with the 100-period appearing as if it is about to cross from above or below the Containment Zone –back into the Containment Zone- the seconds of data that transpire while the 100-period is actually crossing back into the Containment Zone can be (what feels like) and eternity of volatility with the currency, or stock bouncing around, before finally making the move back into the mean. The bottom line is that if we are going to trade reversals back into (and through) the Containment Zone we must be prepared for excess volatility as traders duke out uncertainty.
Anyway, the main rule is this: The 100-period CCI line must be trading well above the +100-line level, or below the -100-line, before even thinking about a reversal.
If the 100-period CCI has just barely traded above the +100-containment line, and then fails, we might assume that simple mean-bound choppy trading is really the name of the game in the near-term, instead of looking for a larger reversal. (That is, unless some sort of fundamental news has surfaced making us think differently.) What I'm saying is if CCI is just "flirting" with the topside +100 oscillator level, but did not make a pronounced move above, implementing a short position would likely be more presumptuous than calculated.
To hammer home my point, when the 100-period CCI line is trading 'almost at', or above the -100-Containment Zone line, taking a short position is a low probability scenario, as jittery trading could easily bring about a pop up into the mean, or higher, where we would likely be stopped out.
High probability (overbought) reversals [meaning the bull-trend could be nearing an end and a sharp downside move could potentially be pending] generally surface when both short-term (21-period) and long-term (100-period) CCI lines are trading well above the +100 oscillator level, or below the -100 oscillator level.
When the short and long-term CCI lines are at the extreme ends of the oscillator, 'trend capitulation' or 'the fifth wave,' in terms of Elliot Wave Theory could be in effect.
I would like to mention that several years ago, it seemed like CCI rarely moved above, or below -250, or +250 in the CCI oscillator; however, with more volatility these days…the occurrence is commonplace. Thus, when I mention 'extreme values' within the CCI oscillator window, we must remember to use common sense, while also making sure to note that increased volatility in the current market, could push values further above and below +100 and -100 than in recent years. You may have noticed in Figure 6.7, when the 100-period CCI-line was trading well above the +100 Containment Zone line (not "just flirting" with it), the occurrence foreshadowed a large reversal looming on the hourly chart, which could have provided significant opportunity for savvy traders.
What's more, you will also notice that the 21-Period CCI line crossed BELOW 100-period CCI - while STILL above the +100-Containment Zone line…and then subsequently fell under +100 towards the mean. In essence, we are basically saying "I want to see longer-term momentum rapped out with short-term momentum also overheated, before even considering the possibility of looking for a reversal."
It's important to note traders will need to configure their CCI time periods to best fit each chart timeframe traded; however, 21-period and 100-period CCI can be used as initial benchmarks.
Moreover, never ever, ever, ever, ever, ever, ever, ever trade without a stop and never take on more risk your account can handle. When in doubt stay out.
While there a many more examples of CCI trading, everything we've discussed here are a great starting point for traders who are not only seeking to help identify trend –in an effort to increase discipline– but may also help one identify reversals and most importantly…give additional guidance when to 'stay out' of the game, should choppy mean-bound trading seem in the cards over the near term.
With everything that we've covered in Part One of Volatility Illuminated, I'm thrilled to now move into Part Two, where we will really dive into volatility and probability, while also taking a very close look at VWAP and of course WVAV and WAVE • PM.
The information you are about to read –as far as I know -is nowhere else readily available for traders within markets, or on the Internet. I have spent hundreds of hours preparing the following pages of Volatility Illuminated. The information you're about to read is NOT a re-hash of someone else's stuff… What you are about to read came from REAL trading, which I discovered only after countless hours grinding it out in markets with real money.
Some of the gems you're going to read about were discovered through massive losses (always a great place to discover incredible insights) and some were unearthed through long strings of wins- carving out similar data (outside of traditional market knowledge) to refine and shape in preparation of the information here. What I'm saying is even if at the end of the book, you're like, 'geez, that sucked, I'd like my money back,' I'm okay with it, because I plan on using the information here in my own trading –because it was derived from REAL trading– not sitting behind a 'strategy tester' looking back into history.
What you're about to read was uncovered with real cash, in real time and I will continue to use the information with my own real cash, long after you have put the book down. I hope you are able to take a ton away from the following pages, though as always, please remember to trade safely and of course: common sense is king.
Even though we're not even close to the end of the book yet, I would like to mention that I appreciate you having purchased this book… Should I swing for the fences [again] trading -when I'm like, 60; you sleep easy knowing you helped pay for my room at the old folks home. I will do my best to convert the Bingo hall into a trading floor though. Anyway, I hope you enjoy Part Two, and please remember to keep an open mind...
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Reader Response
July 1, 2009
Dear Mark,
Your book is very powerful, a real game changer... an absolute work of genius."
N e w t o n illuminated natural forces, Einstein illuminated energy and now your work/book has finally broke through and illuminated the forces and energy behind price action and volatility in the markets... (Brilliant!)
On a personal note, my office book shelves are filled with trading books on all the popular subjects... personal psychology, money management, fundamental and analysis, technical analysis, etc... and at the end of the day, they start to all pretty much sound the same... I am actually embarrassed to admit how much time and effort I have put toward trying to learn and make all that stuff work.
Then comes along your book... The first read instantly changed my whole way of thinking and my approach to markets...
And yes, the chapter on Dr. WaterMelon Stuffer...really pulled the curtain back, and your analogy made perfect sense.
Chad V
Las Vegas, Nevada
Author | Volatility Illuminated
