The Commodity Channel Index or CCI is a technical analysis indicator used by traders to look for unusual price activity to help identify when a commodity is overbought or oversold.
It was originally developed in 1980 by Donald Lambert for commodity trading but its use has now grown to include equities, currencies and futures. It is a common feature on many trading platforms.
The CCI index was developed by Lambert as a way of finding the optimal time to enter seasonal commodities markets. Calculating the CCI is complicated, involving use of a moving average, a mean deviation and Lambert’s standard devisor. Fortunately, trading platforms will do the number crunching for you these days.
For the mathematicians among you, the sums look like this:
CCI = (Typical price - 20-period SMA of TP) / (.015 x Mean Deviation)
The typical price (TP) is the mean of the high, low and close price: (High + Low + Close)/3
Lambert set the constant at .015 to ensure that approximately 70% to 80% of CCI values would fall between -100 and +100.
There are four steps to calculating the Mean Deviation:
1. subtract the most recent 20-period average of the typical price from each period's typical price
2. take the absolute values of these numbers
3. total the absolute values
4. divide by the total number of periods (20).
As we said before, most trading platforms do the sums for you.
The CCI is an unbounded oscillator, which means that its values have no top and bottom limits but Lambert’s devisor ensures that the majority of calculations will be in the -100 to +100 range. Lines are normally drawn at the positive and negative 100 points as boundary indicators.
These markers indicate the beginning of the oversold and overbought areas but different markets will have different extremes, with ETFs, for example, tending to reach less extreme values than shares, which can easily get to 200 on the CCI. The parameters of the CCI can be adjusted to take into consideration the behaviour of the asset, with more volatility leading to higher values.
The number of periods used for calculation of the Commodity Channel Index can also vary, with 20, 30 or 40 being common. A period can be anything from one minute upwards. Shorter periods will give more signals.
Two timeframes can also be used together on a CCI chart to examine a trend using a long-term chart and opportunities to buy and sell within that trend using a short-term one.
To apply the indicator to a certain instrument, you must first select the time scale and display the price of the instrument on your chosen 1-min, 5-min, 1-hour or 1-day scale. Then you must apply the indicator with the specified period parameter. You can use, for example, an indicator on a 5-minute timeframe with a parameter of 10 or on a daily timeframe with a period of 10.
Oversold and overbought
The CCI indicator will be relatively high when prices are well above average and relatively low when they are far below average as it measures how far the current price is moving away from the average price.
As with other oscillators, hitting the recognised marks for oversold and overbought conditions can be clues that a price correction and a return to more usual levels is on the way.
If the CCI oscillator falls below -100 this indicates a strongly oversold state and is a recognised time to buy. Conversely when the oscillator goes past the +100 mark it is indicative of a strongly overbought state and is a cue to sell.
But assets that are on strong trends, either up or down, can sometimes continue that trend well into the further reaches of the index.
CCI trading strategy
The CCI can be used to time entries on an uptrend by waiting for the indicator to fall below the -100 oversold mark and then purchasing when it moves back into the main range. This allows traders to buy when the momentum is back in the direction of the general trend. If the reverse happens, it’s a sell signal.
Making use of market momentum is another way of using CCI. When the oscillator breaks through the +100 mark a long position can be taken which will be closed as soon as the asset is trading within the standard range.
And if the CCI value falls below the -100 mark this can be used as a signal for a foray into short-selling. When the index moves back into the standard range the position can be closed.
When the current price behaviour and the CCI diverge it can be an indication that the price may be about to reverse. For example, if the CCI is rising but making lower highs than the rise in price, it can signify a weakening in the bullish move.
However, divergences may be false friends in a strong trend, with any number of them appearing before the trend goes into reverse.
The chart above shows the share price of supermarket Morrisons at the top, with the CCI as the green line at the bottom.
The CCI line reflects the general trend of the share price but the extremes of the CCI line do not necessarily coincide with the highest share price. For example, in November the CCI gives its highest positive reading but the share price is nowhere near its highest level.
All indicators work better in tandem with others, so it makes sense to combine CCI trading with other technical analysis tools to get the most out of your trading. This will help you confirm or dismiss the signals that the CCI is giving.
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