The CCI also is effective as an overbought and oversold indicator. It oscillates between two extremes. High readings imply an overbought condition (shorts can be taken) and low readings imply an oversold condition (longs can be taken). However, identifying overbought and oversold levels can be tricky with the CCI because of the following reasons:
- The CCI technically has no high or low limit as per the traditional calculation.
- Markets can remain overbought or oversold for extended periods of time.
Regarding the level to use, typically +100 and –100 work when trading a stock in a trading range, while higher levels, such as +200 and –200, are necessary during trending moves.
Using overbought/oversold levels effectively also depends on the volatility of the underlying security. For example, the CCI range for ETFs generally is lower when compared to individual stocks such as Apple and Google. Here are some trading rules for overbought/oversold readings during a trending market:
- Buy when the CCI turns up from below –200 with a stop loss as the previous day’s low. Profit should be booked on a break of the subsequent three-day low.
- Sell when the CCI turns down from above 200 with a stop loss as the previous day’s high. Profit should be booked on a break of the subsequent three-day high.
“Trading at extremes” (below) shows Alcoa Inc. (AA) with a 20-day CCI on a daily time frame. On Sept. 14, 2012, Alcoa closed at $9.84 after making a high of $9.93 and a low of $9.78, with the CCI at 259.65. On Sept. 17, the stock opened at $9.72 and the CCI moved below 200, giving us a signal to initiate the trade with a stop loss of $9.93. The stock started its correction and made a low of $8.65. As per our profit-taking rule, we exit the stock on a break of the three-day low, which was triggered on Sept. 26 when $8.81 was broken.