Commodity Channel Index

Advertisement

Introduction

The sign of a good technical indicator can be measured by how many different trading venues use it. The Commodity Channel Index indicator was originally developed to trade commodities and saw its use expanded when it was applied to several popular trading systems such as Ken Woods’ Woodies club. Today, the Commodity Channel Index is used by equity, forex, and commodities traders in many different trading ways. The CCI is primarily used as an oscillator for ranger trading and also to identify the beginning of new trends.

Through his analytic study of price action, Donald Lambert observed that there were certain repetitive movements in price action that was similar to the rhythmic cyclical action of a sine wave. In his quest to identify the tops and bottoms of sine wave-like price action, Lambert created the Commodity Channel Index (CCI). The CCI was officially introduced to the trading community, when Commodities magazine in October of 1980 published an article by Lambert where he discussed his use of the CCI in a programming experiment linked to trading cycles.

Since its introduction, the indicator has grown in popularity and is now a very common tool for traders to identifying cyclical trends not only in commodities, but also equities and currencies. It can be used as an oscillator, to identify an overbought level when the CCI is above 200, and an oversold level when the CCI is below the -200 line. The CCI can also be used to identify the beginning of a trend when the CCI crosses above the 100 line or below the -100 line and the end of a trend when it crosses back over the line. Some traders use the CCI also as a pattern indicator, with strategies based upon the patterns created by the momentum line, and trend lines are drawn on the CCI instead of the prices.

Formula

The Commodity Channel Index is calculated as the difference between “the typical price” of a commodity and its simple moving average, divided by the mean absolute deviation of “the typical price”. CCI is usually scaled by an inverse factor of 0.015 to provide more readable numbers.

  1. Calculate the Typical Price = (High + Low + Close) / 3
  2. Calculate the simple moving average
  3. 3. Use a stabilizing factor (0.15)
  4. 4. Calculate the absolute mean deviation

Advertisement

Indicator Interpretations

The formula creates an oscillator that will move above and below the zero line. The zero line is the point where price crosses its moving average. 70 to 80 percent of price action will trade between -100 and +100.The Commodity Channel Index can be used to identify price reversals, price extremes and trend changes. Like many oscillators, the CCI can be used to detect divergences from price trends to signal change in price trends. Some traders use the CCI similarly to Bollinger Bands where they draw patterns on indicator to confirm signals.

Original trading Rules

One of Lambert's initial trading strategies for the CCI focused on movements above +100 and below -100. In his analysis, Lambert observed that about 70 to 80 percent of the CCI values where between +100 and -100. So by focusing on breaks above +100 and below -100, a buy or sell signal will be in force only 20 to 30 percent of the time. When the CCI line moves above +100, a strong uptrend is identified and a buy signal is given. The trade is closed when the CCI line moves back below +100. When the CCI line moves below -100, a strong down trend is identified and a sell signal is given. The trade is closed when the CCI line moves back above -100.

While this strategy is simple to use, it tends to produce too many signals with little profits. Many times the CCI produces premature signals and traders find themselves on losing trades only to be stopped out at the top or bottom. One way to combat early signals is with the use of trend lines so that price action will confirm a change in direction of the trend. 

Overbought and Oversold

Many traders use the Commodity Channel Index to identify extreme levels. Readings above +200 are considered to be overbought and readings below -200 are considered oversold. When the CCI is between -50 and +50 the trading conditions are considered neutral. As with other oscillators when prices reach extreme overbought or oversold conditions, there is a large probability that the prices will revert to normal trading levels. 

The zero line will often be areas of support or resistance on the CCI line. Many traders watch price action that follows when the CCI break the zero line that has been support and resistance. The Zero line also provides a good reference to identify points of the chart where to draw trend lines. Breaks of these trend lines can be used to generate buy or sell signals.

As with most oscillators, the divergence of prices and indicators typically provide good signals to changes in trend direction. A lower peak in the Commodity Channel Index against higher highs in price is negative divergence and is a sell signal. A higher peak in the CCI against lower lows in price is positive divergence and is a buy signal. 

Conclusion

The CCI is a valuable tool to identify potential peaks and valleys in price action, and thus provide investors and traders with strong signals to profit in changes in the direction of price movement of the stocks, bonds, forex and commodities.