Understanding the commodity channel index (CCI) in technical analysis

What is the commodity channel index (CCI)?

CCI is a momentum-based oscillator. Its main purpose is to measure the current price level relative to an average price level over a given period. It helps traders identify new trends and spot overbought or oversold conditions. The CCI indicator is plotted on a separate chart below the main price chart. It oscillates above and below a central zero line. Traders use it to determine the strength of a trend. It helps them see if a price move is gaining or losing momentum. A rising CCI suggests a strong upward trend, while a falling CCI suggests a strong downward trend. This indicator is especially useful for spotting potential reversals.

History and origin of the CCI

The CCI indicator was created by Donald Lambert. He first introduced it in 1980 to analyse the commodity markets. He wanted a tool that could track the cycles of these markets. The indicator was designed to find deviations from the average price, making it very effective for commodities. Over time, traders realised the indicator could be used for other assets too. It became popular for stocks, currencies, and futures. Today, the indicator is a standard tool on most trading platforms and a key part of CCI technical analysis for a wide range of assets.

How CCI works

The basic concept of the CCI indicator is simple. It measures the difference between a price and its moving average. It then compares this difference to the average deviation. This calculation gives a value that oscillates around a zero line. A high positive value means the price is much higher than its average, which is a sign of an overbought condition. A low negative value means the price is much lower than its average. This is a sign of an oversold condition.

The indicator is highly sensitive to price movements. It reacts quickly to changes. The standard baseline values for the CCI are +100 and -100. When the CCI moves above +100, it signals overbought conditions. When it moves below -100, it is considered oversold. These levels act as triggers for traders, signalling potential reversals. The CCI indicator does not have a hard upper or lower limit. It can reach values like +200, +300, or more. This makes it different from other oscillators, with the open range allowing it to show the full strength of a price move.

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How to calculate CCI

To understand the indicator, you need to know the commodity channel index formula. It involves three main steps.

• Step 1: calculate the typical price (TP)

  First, find the typical price for each period. The formula for this is:

  TP = (high + low + close)/3
  You do this for each period in your chosen timeframe. So, for a 14-period CCI, you would calculate 14 typical prices.
• Step 2: calculate the moving average of the typical price (SMATP)

  Next, you calculate a simple moving average (SMA) of these typical prices. The standard is a 14-period moving average.

  SMATP = SMA of the last 14 TPs
  This value represents the average price over the period.
• Step 3: calculate the mean deviation

  This is the most complex part of the commodity channel index formula. First, you find the difference between each period’s TP and SMATP. Then, you take the absolute value of these differences and average them.

  Mean deviation = (1/n)∗∑i=1n​∣TPi​−SMATP∣
  Here, ‘n’ is the number of periods (usually 14). This value shows the average distance of the price from its moving average.
• Step 4: calculate CCI

  Now you can put it all together. The final commodity channel index formula is:

  CCI = (TP−SMATP)/(0.015∗mean deviation)

  The constant 0.015 is a scaling factor. It ensures that roughly 70%-80% of CCI values fall between +100 and -100.

Let’s understand this with an example.

Assume we have 3 days of data.

• Step 1: TPs = 9, 11, 13
• Step 2: let’s say we use a 3-period moving average.
  SMATP = (9+11+13)/3 = 11.
• Step 3: mean deviation

  ∣9−11∣ = 2

  ∣11−11∣ = 0

  ∣13−11∣ = 2

  Mean deviation = (2+0+2)/3 = 1.33

• Step 4: CCI for day 3.
  CCI = (13−11)/(0.015∗1.33) = 2/0.02 = 100

In this example, CCI is 100. This is a very strong move, suggesting overbought conditions.

Fortunately, you don’t need to do these calculations yourself. Trading software does it automatically. But understanding the steps helps you interpret the results better.

How to read and interpret CCI

If you want to know how to use CCI, you first need to learn to read the CCI indicator.

Overbought and oversold levels

When the CCI crosses above +100, the price is considered overbought. It is moving much higher than its average. This can signal that a pullback or reversal is coming. When the CCI crosses below -100, the price is considered oversold. It is moving much lower than its average, signalling that a bounce or reversal is coming.

CCI range

When the CCI stays within the +100 and -100 range, it signals sideways or ranging markets. Prices are not moving far from their average. Traders often use these range breaks as signals. A break above +100 can signal the start of a new uptrend. Similarly, a break below -100 can signal the start of a new downtrend.

Zero line crosses

A bullish signal occurs when the CCI moves from a negative value to a positive value. This means it crosses the zero line from below, suggesting that momentum is shifting from bearish to bullish.

A bearish signal occurs when the CCI moves from a positive value to negative. This means it crosses the zero line from above, suggesting that momentum is shifting from bullish to bearish.

Bullish and bearish divergences

A bullish divergence happens when the price makes a lower low, but the CCI indicator makes a higher low. This means the downward momentum is weakening. It often signals a coming price reversal to the upside.

A bearish divergence happens when the price makes a higher high, but CCI makes a lower high. This means the upward momentum is weakening and often signals a price reversal to the downside.

Trend identification

CCI can also help identify the overall trend. During a strong uptrend, the indicator will often stay in positive territory. It may even stay above +100. During a strong downtrend, it will often stay in negative territory, even below -100.

Best settings and timeframes for CCI

The default setting is a 14-period calculation. This is the best settings for CCI for most traders. It offers a good balance between responsiveness and reliability.

For day traders or scalpers, shorter periods can be used. A 9-period or 12-period CCI is more sensitive. It generates more signals. But it also creates more false signals. Traders must be careful when using shorter periods.

For swing traders or long-term investors, a longer period is better. A 20-period or 30-period CCI is smoother. It generates fewer signals, but they are often more reliable. It is less prone to whipsaws.

Ultimately, the best settings for CCI depend on the asset. For example, highly volatile assets, like cryptos, work well with a longer period that filters out noise. The standard 14-period setting works fine with less volatile assets.

Advanced CCI trading strategies

Experienced traders can try these advanced CCI trading strategies.

However, these strategies do not guarantee profits, and past performance does not guarantee future results.

Overbought/oversold + confirmation from price action

Here, you don’t just trade on an overbought or oversold signal alone. Instead, you wait for confirmation. For a sell signal, wait for the CCI to cross below +100. Then, wait for the price to show a reversal pattern. This could be a bearish engulfing candle or a double top. For a buy signal, wait for the CCI to cross above -100. Then, wait for a bullish reversal pattern. This is a powerful combination for CCI technical analysis.

CCI + moving average strategy

This strategy combines 2 popular indicators. Use a long-term moving average (such as a 50-period EMA) to determine the trend. In an uptrend, you only take buy signals from the CCI. This is when the CCI dips below -100 and then crosses back above it. This is a ‘buy the dip’ strategy. In a downtrend, you only take sell signals or when the CCI rises above +100 and then crosses back below it. This is a ‘sell the rally’ strategy.

CCI + MACD/RSI/parabolic SAR

Using the CCI indicator with other tools improves reliability.

CCI + RSI

Both are momentum oscillators, but are calculated differently. A bullish signal from both can be a very strong sign. For example, a bullish divergence on both CCI and RSI at the same time.

CCI + MACD

Use moving average convergence divergence (MACD) to confirm the trend. If MACD is in an uptrend, look for CCI buy signals. If MACD is in a downtrend, look for CCI sell signals.

CCI + parabolic SAR

Parabolic SAR is a trend-following tool. Use the CCI for entry signals. For example, when the parabolic SAR flips to bullish, wait for a CCI buy signal.

Divergence-based setups

CCI divergence is one of the most popular CCI trading strategies.

During a bullish divergence, wait for the price to make a new low and CCI to make a higher low. This signals a loss of selling pressure. Enter a long position when the CCI crosses back above -100.

For a bearish divergence, wait for the price to make a new high and CCI to make a lower high. This signals a loss of buying pressure. Enter a short position when the CCI crosses back below +100.

Multi-timeframe CCI strategy

Use a longer timeframe (such as a daily chart) to find the main trend. Use a shorter timeframe (such as a 4-hour chart) to find entry signals. On the daily chart, if the CCI is in positive territory, the trend is up. On the 4-hour chart, wait for the CCI to drop to an oversold level. Enter a long position when it moves back above -100. This way, you are trading with the main trend.

Volume-based CCI filtering

Volume can confirm CCI signals. A strong CCI signal with high volume is more reliable. For example, a bullish CCI divergence on high volume is a stronger signal than on low volume. It suggests institutional interest is behind the move.

CCI trendline break strategy

Draw a trendline on the CCI chart. This is different from drawing on the price chart. In an uptrend, draw a trendline connecting the lows on the CCI. A break below this trendline can signal a change in momentum. In a downtrend, draw a trendline connecting the highs on the CCI. A break above this trendline can signal a change in momentum.

Practical tips and risk management with CCI

Even with the best CCI trading strategies, you need good risk management.

Avoiding false signals

The CCI indicator can generate false signals, especially in choppy or sideways markets. Always combine CCI with other indicators or with price action analysis.

Combining CCI with trend filters

A trend filter can help reduce false signals. A simple moving average is a good example. Take buy signals only when the price is above the moving average and sell signals only when the price is below it.

Stop-loss strategies

A common strategy is to place the stop-loss just outside the recent high or low. For a buy signal, place the stop-loss below the recent low. For a sell signal, place it above the recent high. Another strategy is to use the CCI itself. For a long position, set a stop-loss when the CCI crosses below the zero line. This suggests that momentum has shifted.

Identifying ranging vs. trending markets

CCI will often oscillate between +100 and -100 in ranging markets. These are good conditions for overbought/oversold strategies. CCI will often stay in positive or negative territory for a long time in trending markets. It may spike to extremes and then pull back slightly. Here, zero-line crosses and trend-following strategies work better.

Pros and cons of using the CCI indicator

The CCI indicator can be used on any market and any timeframe. Plus, it is a leading indicator. It can signal reversals before the price chart does. The CCI divergence is a great example of this. Also, it is great at showing the strength and direction of a trend.

However, the indicator can be too sensitive. It can give false signals, especially with shorter timeframes. The best settings for CCI can be subjective. What works for one trader might not work for another. As with all indicators, the CCI is not perfect. It is best to confirm signals with other indicators.

CCI vs. other momentum indicators

The CCI indicator is just one of many momentum tools. Let’s compare it to a few others.

CCI vs. relative strength index (RSI)

RSI measures the speed of price changes. It ranges on a scale of 0 to 100 while CCI is not bound by a range. This means CCI can show more extreme price moves. Some traders prefer CCI for its ability to show new extremes in a strong trend. The RSI is often better for identifying overbought/oversold conditions in a range.

CCI vs. moving average convergence divergence (MACD)

MACD is a trend-following momentum indicator. It tends to lag the CCI. CCI is better for early signals, while MACD is better for confirming an established trend.

Learn more about using the MACD trading strategy.

CCI vs. stochastic oscillator

The stochastic oscillator compares a closing price to its price range. It is similar to the RSI, with a 0-100 range. It is often used for reversals in a choppy market. CCI is often better at spotting trend strength.

Real-world examples and use cases

Forex trading

Let’s say you’re watching the EUR/USD pair on a 4-hour chart. CCI has been trending downwards, reaching below -100. Then, the price makes a lower low, but the CCI indicator makes a higher low. This is a bullish CCI divergence. Wait for the CCI to cross back above -100 to enter a long position. If the price reverses and a new uptrend begins, you stand to earn a profit.

Stock trading

Let’s say you’re trading a tech stock. The stock price has been rising steadily for months. The CCI indicator has stayed mostly in positive territory, confirming the uptrend. One day, the price spikes up sharply and CCI soars to +250. This is an extreme overbought reading. You could decide not to buy more. A few days later, the price pulls back and CCI falls. So, you were able to avoid buying at the top.

Crypto trading

Let’s take the example of bitcoin. CCI crosses the zero line from below, moving into positive territory. This is a bullish signal. You decide to open a long position. CCI continues to rise, confirming a strong uptrend. This is an example of using the zero-line cross strategy for early trend identification.

How reliable is the CCI indicator?

CCI is a potentially reliable tool, but it isn’t a holy grail. Its statistical reliability can be notable when used correctly. However, do not rely on the CCI alone. Combine it with volume and confirmation indicators to increase reliability.

For instance, use a volume indicator to check for high volume on a CCI signal. Use indicators like the moving average or MACD to confirm CCI signals. Also, look at the price action on the chart. Is the price breaking a key support or resistance level? This confirms the CCI signal.

The CCI indicator is a technical analysis tool that can help traders understand market momentum. It can signal reversals and identify new trends. Just remember to practice risk management and never rely on a single indicator.

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