It gained its name because it was originally used to Analyze commodities.
Developed by Donald R. Lambert in 1980. The Commodity Channel Index (CCI) is a versatile indicator that can be used to identify a new trend or warn of extreme conditions. Lambert originally developed CCI to identify cyclical turns in commodities, but the indicator can be successfully applied to indices, ETFs, Stocks, and Other securities.
In general, CCI measures the current price level relative to an average price level over a given period of time. CCI is relatively high when prices are far above their average. CCI is relatively low when prices are far below their average. In this manner, CCI can be used to identify Overbought and Oversold levels.
The CCI is classified as an “Oscillator” since the majority of values fluctuates between values of “100” and “-100”. The indicator typically has lines drawn at both the “100” and “-100” values as warning signals. Values exceeding these boundary limits are interpreted as a strong overbought condition, or “selling” signal when over “100”, and if the curve dips below “-100”, a strong oversold condition, or “buying” signal, is generated.
The example below is based on a 20-period Commodity Channel Index (CCI) calculation. The number of CCI periods is also used for the calculations of the Simple Moving Average (SMA) and Mean Deviation.
CCI = (Typical Price - 20-period SMA of TP) / (.015 x Mean Deviation)
Typical Price (TP) = (High + Low + Close)/3
Constant = .015
There are four steps to calculating the Mean Deviation :
First, subtract the most recent 20-period average of the typical price from each period's typical price.
Second, take the absolute values of these numbers.
Third, sum the absolute values.
Fourth, divide by the total number of periods (20).
This equation basically tells us that the Commodity Channel Index grabs the typical price value (Candle High x Low x Close / 3) and then works out the difference between the Moving Average period value set by the user. This value is further divided by 0.015 x D (where D is mean deviation).
The bottom line is the Commodity Channel Index is another one of those indicators using a moving average in its core calculation. This raises a yellow flag straight away because moving averages lag and that is going to directly affect the output of the CCI by producing a lagging value.
The theory behind the use of the Commodity Channel Index (CCI) is so trader can clearly see when the Market is ‘Overbought’ and ‘Oversold’.
The general idea is to get into the Market when the price hits the High range or a Low range. It reveals where the Market will be exhausted and is likely to Reverse.
When the Commodity Channel Index (CCI) moved into the Overbought range (>+100) the Market soon Reversed and sold off.
When the market dived into the Oversold range (<-100) we soon seen the Market find some footing and starting climbing Higher.
Divergences signal a potential reversal point because directional momentum does not confirm price.
A Bullish divergence occurs when the underlying security makes a lower low and CCI forms a higher low, which shows less downside momentum.
A bearish divergence forms when the security records a higher high and CCI forms a lower high, which shows less upside momentum.
Before getting too excited about divergences as great reversal indicators, note that divergences can be misleading in a strong trend. A strong uptrend can show numerous bearish divergences before a top actually materializes. Conversely, bullish divergences often appear in extended downtrends.
Confirmation holds the key to divergences. While divergences reflect a change in Momentum that can foreshadow a Trend reversal, chartists should set a confirmation point for CCI or the price chart. A Bearish divergence can be confirmed with a break below zero in CCI or a Support break on the price chart. Conversely, a Bullish divergence can be confirmed with a break above zero in CCI or a Resistance break on the price chart.
Oscillating trading tools like the Commodity Channel Index help traders identify when markets are reaching the end of an existing trend.
When markets have been in a trend state for an extended period, they can sometimes go too far or overshoot.
When this happens efficient markets tend to pullback, or trade at previous prices, as the price discovery process of trading verifies the True value of the instrument. The CCI is a trading tool that provides investors with reasonable evidence to estimate pending changes in the direction of asset prices.