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This is a quick look at using the Commodity Channel Index (CCI) as a contrarian indicator to trade the stock market. I’m just starting to dig my teeth into CCI and I’m not proposing this as the best use, just a use.

Unfamiliar with the CCI? Read this StockCharts.com primer. In a nutshell, CCI looks at how far an asset has diverged from its moving average relative to how far it “normally” divergences. CCI usually oscillates between +/-100, but when the market makes a significant move, will exceed those levels.

Strategy rules follow the graph.

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2009011901
[logarithmically-scaled]

The graph above shows my CCI(4) approach (red) trading the S&P 500 from 1985, compared to buy & hold (blue). These results do not account for transaction costs, slippage, or return on cash, but could be more or less had with actively-traded mutual funds (i.e. ProFunds or Rydex).

Strategy Rules: Go long at today’s close when the four-day CCI closes below -100 and exit that position when the 4-day CCI closes above 0. This strategy is long-only.

Getting past all of the mathematical shenanigans, this strategy is simply going long when the market makes a significant drop below its four-day average, and exiting when it closes above that four-day average.

We’ll look at the numbers in a moment, but the graph is pretty clear that the strategy has not done well in terms of total return, but has been very consistent over the last 20+ years and has done an excellent job of avoiding protracted market drawdowns, with very little time in the market (~32% exposure).

I think that (a), the infrequency with which it trades; (b), its consistency and (c), its low historical volatility makes it a good candidate for a leveraged approach. So let’s have a little geek fun and assume we traded with leveraged 2x mutual funds (note: these are NOT the same as ETFs) and received a return on cash equal to half the nearest three-month Treasury.

click to enlarge

2009011902
[logarithmically-scaled]

A bit more respectable in terms of return with downside volatility (i.e. drawdown) still better than a buy and hold approach. For the number lovers:

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2009011903

A note of caution – even though historically-measured risk here (in terms of volatility and drawdown) is less than the market, the fact that we’ve used leverage adds an additional immeasurable risk – the risk of being caught leveraged long on a massive fat-tail day (a’la October 1987). This is a risk that cannot be ignored, and as always, trade size with care.

Closing Thoughts

I would reiterate that I’m just poking around the edges of the CCI. This is one possible use, but not necessarily, the best one.

The problem with indicators like this that are based on the traded asset’s price, is that they are all more or less iterations of the same exact thing, and as I wrote recently in "The Moving Average Spectrum," in the case of short/intermediate-term indicators like this one, they tend to (at this moment in history) all be contrarian.

CCI will be staying on my radar, and as always, I’ll share any goodies.

[Geek Note: Leveraged mutual funds were not available over the entire period tested, so I’ve simulated returns assuming an annual expense ratio of 2.0%. This is possible due to the high r-square of these funds to their underlying index.]

Source: Using the Commodity Channel Index as a Trading Strategy