If the stock market were like your neighborhood grocery store, supply and demand would stay relatively even-keeled, with the quality of the product reflecting the price, and the price reflecting the number of people in town who buy the product. But in real life, sometimes supply and demand get skewed, and the price of a stock rises or falls artificially, with little reflection on the profitability of the company itself.

One way to detect whether a stock has been overbought (increased demand, or buying, pushes the price unjustifiably high) or oversold (increased supply, or selling, causes the price to drop below its true value) is to use the Commodity Channel Index (CCI).

The CCI is a banded oscillator that helps investors identify cyclical trends in a broad range of assets. An oscillator moves over time (think of your typical line graph showing a stock's movement in a day), and a banded oscillator moves between a designated high and low value. In the case of the CCI, the high and low values are -100 and +100.

Let's take a look at how this works, starting with how we calculate CCI:

View Graphic

Typical price is the average of the high, low and closing prices of the security. SMATP stands for the simple moving average (SMA) of the typical price (over a 15-bar cycle), and mean deviation is the average of the absolute values of SMATP minus typical price, also over a 15-bar cycle. The .015 multiplier was included by the creator of the CCI to make the resulting numbers more digestible and ensure 80% of figures fall into the -100 to +100 band.

Sounds confusing. Even if you don't remember absolute values from high school and calculating any kind of deviation makes you break out in a cold sweat, you can still use CCI. The key is being able to interpret CCI graphs in ScottradeELITE even if you aren't doing the calculations yourself.

To graph CCI in ScottradeELITE:

1. Open a new chart window by clicking the Chart button at the top.
2. Click once on the Studies button at the top of your Chart window.
3. Put your mouse cursor on Add New Study.
4. Click on Commodity Channel Index from the list that pops up to the right of your cursor.
5. Customize your chart colors and display, and click OK.

When you graph CCI, you'll see the -100 to +100 band mentioned earlier. Ideally, stocks would stay within the bounds of that band. But, when you see the line rise above the +100 mark, you know the stock is likely being overbought, and when the graph dips below -100, the index is telling you the stock is likely being undersold.

Now that you know whether a stock is being overbought or undersold, then what? Like any indicator or oscillator, CCI is best when used in conjunction with other technical indicators. CCI can help investors identify potential peaks and valleys in the security's price, which helps you make reasonable estimates of changes in the direction of the price. It's impossible to predict the exact movements of an asset, but technical analysis oscillators like CCI can help you make an educated guess.

Any securities, analytical tools, or strategies described in this article are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision.