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 in 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. (See also: Exploring Oscillators and Indicators.)
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.
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:
- Open up the stock's yearly chart.
- Locate two highs or two lows on the chart.
- Take note of the time interval between these two highs or lows (cycle length).
- 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 Oracle Corporation (ORCL):
Figure 1: Chart courtesy of StockCharts.com
Here we can see that one cycle (from high to high) starts at Sept. 11 and finishes on Jan. 29. This represents roughly 140 trading days, which, divided by three, gives a time interval of about 47.
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 Oracle:
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: An Introduction to Oscillators.)
Here are the basic rules for interpreting the CCI:
Possible sell signals:
- The CCI crosses above 100 and has started to curve downward.
- 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:
- The CCI crosses below -100 and has started to curve upward.
- There is a bullish divergence between the CCI and the actual price movement, characterized by upward movement in the CCI while the price of the asset continues to move downward or sideways.
A possible supplement to the CCI is the use of candlestick patterns (shown as supplements within the charts above), 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). All price trading ranges are flexible, but the CCI is designed to take advantage of prices that have exceeded normal movements and are likely to snap back. Traders might look to sell their holdings or covered calls when the CCI is very high or make an additional purchase when the CCI is very low. (For more, see: Using Trading Indicators Effectively.)
Don't Rely Solely on CCI
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.
Like any other momentum oscillator, the CCI is not designed to be used as a standalone tool. It may be more effective to complement this indicator with another technical tool, such as a price channel. Traders must also adjust their CCI entry and exit thresholds based on the volatility of the underlying security; for example, an index exchange-traded fund (ETF) is traditionally less volatile than an individual stock issue.
The Bottom Line
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 indicators. (For related reading, see "How Traders Use CCI (Commodity Channel Index) to Trade Stock Trends")