The Commodity Channel Index (CCI) is an oscillator originally developed by Donald Lambert and featured in his book "Commodities Channel Index: Tools for Trading Cyclical Trends". Since its introduction, the indicator has grown in popularity and is now a very common tool for traders to identify cyclical trends not only in commodities but also equities and currencies. In this article, we'll take a look at what exactly the CCI calculates, and how you can apply it to enhance your trading.

Understanding the CCI
Like most oscillators, the CCI was developed to determine overbought and oversold levels. The CCI does this by measuring the relation between price and a moving average (MA), or, more specifically, normal deviations from that average. The actual CCI calculation, shown below, illustrates how this measurement is made.


ATTimingTrades1.gif
The one prerequisite to calculating the CCI is determining a time interval, which plays a key role in enhancing the accuracy of the CCI. Since it's trying to predict a cycle using moving averages, the more attuned the moving average amounts (days averaged) are to the cycle, the more accurate the average will be. This is true for most oscillators. So, although most traders use the default setting of 20 as the time interval for the CCI calculation, a more accurate time interval reduces the occurrence of false signals. Here are four simple steps to determining the optimal interval for the calculation:

  1. Open up the stock's yearly chart.
  2. Locate two highs or two lows on the chart.
  3. Take note of the time interval between these two highs or lows (cycle length).
  4. Divide that time interval by three to get the optimal time interval to use in the calculation (1/3 of the cycle).
Here's an example of this method applied to Sun Microsystems (SUNW):



ATTimingTrades3.gif Figure 1: Chart courtesy of StockCharts.com

Here we can see that one cycle (from low to low) starts at Oct 6 and finishes on Aug 9. This represents roughly 225 trading days, which, divided by three, gives a time interval of about 75.

Applying the CCI
Since it was invented, the CCI calculation has been added as an indicator to many charting applications, eliminating the need (thankfully) to do the calculations manually. Most of these charting applications simply require you to input the time interval that you would like to use. Figure 2 shows a default CCI chart for SUNW:



ATTimingTrades2.gif Figure 2: Chart courtesy of StockCharts.com

Note that the CCI actually looks just like any other oscillator, and it is used in much the same way. (To learn more about oscillators, see Getting to Know Oscillators.) Here are the basic rules for interpreting the CCI:
Possible sell signals:


  • The CCI crosses above 100 and has started to curve downwards.
  • There is bearish divergence between the CCI and the actual price movement, characterized by downward movement in the CCI while the price of the asset continues to move higher or moves sideways.
Possible buy signals:



Figure 3 shows another chart of SUNW, but for this chart, the time interval of 75 (which we calculated above) was used for the calculation:



ATTimingTrades4.gif
Figure 3: Chart courtesy of StockCharts.com

The red arrows show turning points that emit sell signals, while the green arrow shows a turning point emitting buy signals. The short blue lines, indicating the impending trends, show the divergence between the CCI and price.

Always Get Confirmation
It is extremely important - as with many trading tools - to use the CCI with other indicators. Pivot points work well with the CCI because both methods attempt to find turning points. Some traders also add moving averages into the mix. In Figure 3 above, you can see that the 60-day exponential moving average (violet horizontal line) provides a good support level; however, determining which MA level is best varies by stock (to learn more, see Introduction To Moving Averages ).

Another possible supplement to the CCI is the use of candlestick patterns, which can help confirm exact tops and bottoms throughout the CCI's "selling period" (time in which it is above 100) or "buying period" (time in which it is below -100).

Conclusion

The Commodity Channel Index is an extremely useful tool for traders to determine cyclical buying and selling points. Traders can utilize this tool most effectively by (a) calculating an exact time interval and (b) using it in conjunction with several other forms of technical.

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