Invest Better with Market Timing Tools: CCI Technical Indicator and the Stop Limit

What's important to remember when timing the market is that you have to be right twice: when you buy and when you sell. If you trade often, you have to be right twice each time. This is not easy, which is why market timing is usually left up to professionals.

Most financial advisors advise against market timing as amateurs tend to make mistakes and get burned--buying high, shrieking when they see the share price fall, then selling low. In fact, timing the market is very much looked down upon by the financially "savvy" and is considered, along with day trading, to be almost akin to a four-letter word.

But if market timing is such a dumb thing to do, why do so many well-educated, smart professionals do it? And why do stock-trading firms make buckets of money?

The fact is, traders earn muchos dineros timing the market, but they don't do it like the average investor, blundering in on a whim and cashing out in a panic. They enter and exit the market based on educated guesses as to where stock prices are headed. They use sophisticated tools to do this, including a myriad of technical indicators, calls, puts, shorts and other financial instruments.

I'm going to share two of these market timing tools with you: the CCI technical indicator and the "stop limit"; both are easy to understand and simple to use.

The CCI Indicator

The commodity channel index, or CCI, was designed to identify pricing cycles in commodities. It's based on the assumption that commodities move in cycles, with highs and lows coming at periodic intervals. (For more on CCI, click here.)

Without going into the math behind this, suffice it to say that when you use this indicator to track a specific equity, it is considered to be at the top of a pricing cycle when CCI is above +100 and at the bottom of a cycle when it's below -100. In other words, at CCI +100 the equity is considered "overbought" (getting ready to fall in price) and at CCI -100 it's "oversold" (getting ready to rise).

If you go to StockCharts.com you can see this graphed out for you. (Plug the ticker symbol of your stock, bond, ETF or mutual fund into Sharp Charts, then under "Indicators" select CCI.)

One way traders use this indicator to help with market timing is to buy equities when they're below CCI -100 (the red zone in the graph) and sell when they're above CCI +100 (the green zone). Or if they want to short an equity they begin shorting when it's above CCI +100 and cash in when it's below CCI -100.

Once you've bought your shares, everything changes. You're no longer a passive observer. You now have a portion of your hard-earned savings directly exposed to the vagaries of the market.

If you're like me, this can be nerve wracking. Yes, you bought the stock when its share price was below CCI -100 and you know intellectually that you should wait until it tops CCI +100, but who's to say it'll keep going up?

Maybe it'll go back down, dipping further (which can happen, by the way). Maybe it'll go "sideways" (not really rising or falling, but limping along in a very narrow price range). Yes, eventually it'll probably rise above CCI +100, but how long will that take?

The Stop Limit

One way to protect yourself from a sudden drop in share price is to set up a "stop limit." This is actually two things: a "stop" and a "limit."

Think of a stop as a way to stop you from losing money should a stock fall in value. You set a stop by inputing a price at which you want your shares to be sold should the stock fall in value.

You then set a limit by inputing a price at which you want your stop to become inactive should the stock fall in value below the stop price. A limit is necessary because sometimes stocks fall very quickly in price, so fast that your shares can't be sold at your stop price.

What happens in this scenario is that your shares will be sold as soon as the stock reaches a price level at which buyers can be found; and this can sometimes be far below your stop price, so low, in fact, that you could lose a substantial amount of your investment.

Let me give you an example to illustrate the stop limit. I once bought shares of DBA (an exchange-traded fund that tracks agricultural commodity prices) at $36 apiece. It subsequently rose above $37 and I was nervous it might fall again, so I set a stop at $36.50.

In case of a sharp fall in price, and my shares getting sold below what I had purchased them for, I set my limit price at $36.10. If DBA fell below that level, my shares would not get sold.

What happened? DBA did fall in value, as I had feared, and my shares were sold at $36.43, so I made a little money on the trade.

As this example shows, the CCI indicator and the stop limit can help you when it comes to market timing. You can enter and exit the market using CCI signals alone, or enter the market and use the stop limit to protect you from sudden share-price declines. Either way, you're better off than just trusting dumb luck.

You may be wondering what happens if the share price falls so suddenly it triggers your limit price and your shares are not sold off. Well, then you still have your shares, and the best you can hope for is that they'll rebound in value at some point in the future. (God willing.)

NOTE 1: Fellow AC Producer Irene Lynn introduced me to these investment tools (and I strongly urge you to read her work), although I bear sole responsibility for any errors in this article.

NOTE 2: You invest at your own risk. The author and this Web site cannot be held responsible for investment losses incurred by readers of this article. (Be careful. You could lose your shirt.)