How to trade using the commodity channel index (CCI)

Introduction

Technical indicators are calculated from price data to provide traders with information that cannot be easily shown from pure prices, such as momentum and volatility. Indicators have two major classifications: trend-following, such as moving averages and Bollinger Band, and oscillators like the commodity channel index (CCI) and Stochastics.

What is the commodity channel index (CCI)?

The commodity channel index was first described by Donald lambert in the October 1980 Issue of commodities magazine. Lambert originally developed the CCI to identify cyclical turns in commodities, but the indicator can be successfully applied to indices, ETFs, stocks, and other securities.

 The CCI formula creates a conveniently used number that statistically expresses how far recent prices have departed from a moving average. In this manner, CCI can be used to identify overbought and oversold levels.

CCI calculation

The CCI formula calculates a simple moving of average daily prices and then calculates the mean deviation. The mean deviation is the sum of the differences between each period’s average price and its simple moving average. The mean deviation is then multiplied by a constant 0.015 and divided into the difference between the simple moving average and today’s average price. 

The trader can vary the number of periods used to calculate the simple shortening. Shorter time spans make the index faster and more responsive to small market movements, while lengthening the time span slows down the index and smooths out the market volatility. 

1. Typical price = (H + L + C) / 3
2. 20 SMA of the typical price 
3. Calculate the mean deviation of price from the 20 SMA
4. MD = abs (TP1 – 20 SMA) + (TP2 - 20SMA) + … (TP20 – 20 SMA) / 20
5. CCI = (Today typical price - today moving average) / MD* 0.015

The CCI is displayed as an oscillator that ranges above or below the zero line, as shown in Figures 1 and 2. Since the index measures how far prices have diverged from a moving average. CCI allows us to measure the strength of the trading trend. The theory is that the higher the CCI value the stronger the trend.

Figure 1

Figure 2

Trading with CCI 

You cannot use the CCI signal alone without taking trend analysis into consideration because every market phase has a different trading characteristic. In an uptrend using CCI to time, the buy signal will always be the best CCI trading strategy, and in a downtrend using CCI to time the short signal.

How to trade using the CCI indicator in an uptrend

During uptrend buyers always have control over price movement and the best trades are always around the end of the downward retracement where the best risk-reward is always so CCI can be used to time the entries.

In a strong uptrend, the CCI indicator will oscillate between the 100 level and zero level, as shown in Figure 3. 

Figure 3

A buy signal is generated when breaking out level 100 and closing the position when the CCI moves below level 100 or the zero line, as shown in Figure 4.

Figure 4

A Buy signal is generated when CCI breaks out the zero-line level but when it does not reach -100, as shown in Figures 5, 6, 7, 8, and 9. 

Figure 5

Figure 6

Figure 7

Figure 8

Figure 9

In a normal uptrend, the CCI indicator will oscillate between the 100 level and -100 level, as shown in Figure 10. 

Figure 10

A buy signal is generated when breaking out level -100, as shown in Figures 11 and 12.

Figure 11

Figure 12

How to trade using the CCI in a downtrend

During downtrends sellers always have control over price movement and the best trades are always around the end of the upward retracement where the best risk-reward is always so CCI can be used to time the entries.

In a strong downtrend, the CCI indicator will oscillate between the -100 level and zero level as shown in Figure 13.

Figure 13

A sell signal is generated when breaking down level -100 and closing the position when the CCI moves above level -100 or the zero line, as shown in Figure 14.

Figure 14

A sell signal is generated when CCI breaks down the zero-line level but when it does not reach 100, as shown in Figures 15 and 16. 

Figure 15

Figure 16

In a normal downtrend, the CCI indicator will oscillate between the 100 level and -100 level, as shown in Figure 17.

Figure 17

A sell signal is generated when breaking down level 100, as shown in Figures 18 and 19. 

Figure 18

Figure 19

Overbought and oversold zones

Identifying overbought and oversold levels can be tricky with the Commodity Channel Index (CCI), or any other momentum oscillator for that matter. 

First, CCI is an unbound oscillator. Theoretically, there are no upside or downside limits. This makes an overbought or oversold assessment subjective. Second, securities can continue moving higher after an indicator becomes overbought. Likewise, securities can continue moving lower after an indicator becomes oversold.

Overbought or oversold levels are not fixed since the indicator is unbound. Therefore, traders look at past readings on the indicator to get a sense of where the price reversed. For one stock, it may tend to reverse near +200 and -150. Another commodity, meanwhile, may tend to reverse near +325 and -350. Zoom out on the chart to see lots of price reversal points, and the CCI readings at those times.

Divergence using CCI Indicator

Most of the time the CCI indicator follows the price movement, but when it does not, we call this a divergence, which indicates a weakness in the current trend.

There are two types of divergence:

1. Positive divergence occurs when the price makes a lower low, but the indicator makes a higher low, which means the current seller is exhausted and loses momentum and a correction might occur.
2. Negative divergence occurs when the price makes a higher high, but the indicator makes a lower high, it means the current buyer is exhausted and loses momentum and correction might occur, as shown in Figures 20, 21, and 22. 

Figure 20

Figure 21

Figure 22