The Commodity Channel Index, also known as the CCI, is a momentum oscillator. Traders use it to identify cyclic trends in assets.
Donald Lambert, the developer of the Commodity Channel Index, first introduced it in his book Commodities Channel Index: Tools for Trading Cyclical Trends.
The CCI is an oscillator that determines oversold and overbought levels by measuring the relationship between moving average and price. Traders can use the indicator to assess the strength of a price trend and direction.
With the indicator, traders can determine if they want to add to an existing position, enter a trade, refrain from taking a trade, or exit a trade.
How to calculate the Commodity Channel Index
Traders can calculate the Commodity Channel Index using the following steps:
- Find out how many periods the CCI will analyse. The most common period is 20. If traders use fewer periods, it results in a more volatile indicator, while more periods make it smoother.
- Track the high, low, and close for 20 periods in a spreadsheet. Then, use the result to compute the typical price.
- Compute the moving average of the typical price after 20 periods. Traders can do this by adding the last 20 typical prices and dividing by 20.
- Subtract the moving average from the typical price for the last 20 periods to get the mean deviation. Add the absolute values of the figures and divide by 20 (ignore any minus sign).
- To compute the current CCI reading, insert the most recent moving average, typical price, and the mean deviation into the formula.
- As each new period ends, repeat the same process.
CCI = (TP – SMA) / (0.015 x MD)
Where: TP is typical price, SMA is simple moving average, and MD is mean deviation.
The image below is a GBP/USD chart on a one-hour time frame showing the Commodity Channel Index
How to use the Commodity Channel Index to improve your trading
Traders use the CCI primarily for spotting weaknesses in trends when the indicator diverges with price, spotting new trends, and watching for oversold or overbought levels.
Once the Commodity Channel Index goes from a near-zero territory to above 100, it means the price may start a new uptrend.
At that point, traders watch for a pullback in the price, followed closely by a rally in both price and CCI to signal a buying opportunity.
For an emerging downtrend, the same concept applies. Once the indicator moves from a near-zero reading to below -100, it shows that price may start a new downtrend. It also signals that traders should start looking out for selling opportunities.
The GBP/USD chart above shows price reacting to the CCI indicator.
With the CCI, traders rely on past readings to determine where price reversed because the levels aren’t stable.
It’s also important to note that there are divergences. These occur when price moves in one direction and the indicator moves in another way.
Divergence is a poor trade signal, but traders can use it to their advantage because it doesn’t always result in a price reversal and lasts for a long time.
It can also warn a trader about a possible reversal, which helps them to hold off on taking new trades in the price trend direction or tighten stop-loss levels.
Pros of the CCI Indicator
The CCI is an effective indicator for spotting market entry points, especially when traders combine it with other indicators.
Cons of the CCI Indicator
Traders use the CCI to spot oversold and overbought conditions, but the indicator is subjective. The CCI has an unbound feature. Therefore, oversold and overbought levels may later have little impact.
The CCI indicator lags and can sometimes provide poor signals.
Therefore, it’s best for traders to use the indicator alongside other indicators, price analysis, and technical analysis to confirm good signals.
The bottom line
In determining cyclic buying and selling points, the Commodity Channel Index is useful, but traders must keep in mind that it isn’t a good standalone tool.
Instead, they can increase the effectiveness of the CCI by combining other indicators like the stochastic Relative Strength Index (RSI). Also, traders should adjust their CCI entry and exit thresholds based on the volatility of the underlying security.