Traders often use mean reversion strategies to profit from volatility and momentum strategies to profit from trends – and both of these strategies rely heavily on momentum oscillators.
Day traders look for short-term moves away from the mean and use scalping strategies to profit from a return to the average, while swing or position traders use the same technical indicators to spot changes in trends. So, it’s important for all kinds of traders to understand how to use popular momentum oscillators to their advantage.
In this article, we will look at one of the most popular technical indicators for these kinds of strategies – the Commodity Channel Index, or CCI.
Click here to know more about technical indicators.
What is the Commodity Channel Index?
The Commodity Channel Index, or CCI, was developed by Donald Lambert and published in Commodities magazine in 1980. The indicator was originally used to identify long-term cycles in commodities, but it has since become popular in equity and foreign exchange market across all timeframes. It’s an extremely versatile momentum oscillator that can be used in both mean reversion or trend trading strategies.
Let’s take a look at what the CCI looks like when applied to the SPDR S&P 500 ETF (SPY):
Content continues below advertisement
The indicator is often plotted above (as can be seen above) or below the price chart as a momentum oscillator. Most traders use a 20-period range with +100 indicating overbought conditions and -100 suggesting oversold conditions. But you can adjust various settings based on your own preferences and experience to suit your needs. It can also be easily incorporated into automated trading systems.
Most traders combine the CCI with other technical indicators to maximize the odds of success. For example, choppy markets can generate several false signals and there’s no built-in stop-loss recommendation. Additional technical indicators or chart patterns can help better inform decisions and reduce the risk of acting on false signals.
Check out our commodities section here to know more about them.
Calculating the Commodity Channel Index
The Commodity Channel Index simply measures the current price relative to an average price over a given period of time.
It’s a common technical indicator that can be found in most charting software packages. But, if you need to manually calculate it, the formula is straightforward.
CCI = (AP – 20-period SMA of TP) / (C x MD)
AP is the average price, or the average of the high, low, and close for a given period (e.g. (High + Low + Close) / 3).
SMA is the simple moving average.
C is a constant. The constant ensures that the indicator’s values oscillate within a range. The convention is to use 0.015 to keep the range mostly between -100 and +100.
MD is the mean deviation (see below).
The mean deviation is calculated in three steps:
Subtract the most recent 20-period average of the average price from each period’s average price. For example, the 20-period average of average prices might be 40.00 and the current period’s average price might be 41.50, which results in a value of 1.50.
Sum the absolute values of those numbers.
Divide the result by the total number of periods.
The CCI can be used with standard charting applications, such as StockCharts.com, or in automated trading systems, using packages like TA-Lib.
Using the Commodity Channel Index
There are many different ways to interpret technical indicators – and the Commodity Channel Index is no exception.
Swing or position traders often use the indicator to predict a breakout or breakdown. If the indicator moves above +100, a buy signal is generated and the trader purchases the security and doesn’t sell until a sell signal is generated. If the indicator breaks below -100, it generates a sell signal and the trader immediately exits their long position or enters a short position. The idea is that the indicator’s extremes signal a shift in the underlying trend.
The CCI indicator can also be used across multiple timeframes. For example, a move above +100 on a long-term chart may justify a bullish bias when looking at shorter-term charts. A trader may only act on buy signals and discount any sell signals in these conditions. The opposite may be true if the long-term chart has a -100 CCI reading.
Day traders may take an entirely different approach to using the indicator. Using a smaller period setting, they may look for mean-reversion opportunities. A CCI reading of +100 could suggest that the stock is overbought and lead to a short position with a take-profit at the mean and a stop-loss set at a certain percentage from the order entry point. The idea is that the short-term price is most likely to return to an average than become more extreme.
Of course, traders should never rely on only a single technical indicator to make decisions. The CCI should be just one part of a much larger toolbox of technical indicators that can inform market timing decisions.
Want to know more about the basics of different commodities? Click here.
The Bottom Line
The Commodity Channel Index, or CCI, is an extremely versatile momentum oscillator. Both chartists and algorithmic traders can use the indicator to spot short-term mean reversion opportunities or long-term trend changes.
Check out our news section to track the latest commodity news—and don’t miss a beat!