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Trading with the Commodity Channel Index (CCI) Indicator in Financial Markets

How to Use the Commodity Channel Index (CCI) to Identify Overbought and Oversold Conditions and Divergences


Hello friends. In previous articles, I talked about the importance of technical indicators as a part of technical analysis. Technical indicators are the most important  tools we need when trading in financial markets. Today, we will discuss another technical indicator, the Commodity Channel Index (CCI) indicator.

What is the Commodity Channel Index (CCI) indicator?

The Commodity Channel Index (CCI) is a momentum indicator that measures how far a price of an asset deviates from its average price. The CCI indicator was created by Donald R. Lambert in the early 1980s. Lambert developed this indicator to provide commodity market traders with an analytical tool to support their trading decisions. The CCI indicator can be used not only in commodity markets but also in other financial markets. It is commonly used to identify overbought and oversold conditions in markets such as stocks, commodities, and other financial instruments. Aside from this, the CCI indicator can be employed to determine trends, identify overbought and oversold levels, and establish support and resistance levels. This indicator tracks price movements and deviations by using the moving average of the typical price.

Calculation of Commodity Channel Index (CCI)

The standard setting for CCI is 20, which means CCI measures price changes over a 20-day period. However, different settings can be used. For instance, a 14-day CCI might be more responsive, while a 50-day CCI could be less sensitive. The optimal setting for CCI depends on the trader's preferences and trading style. The values of the CCI indicator range from 0 to 100. Values above +100 are considered overbought, while values below -100 are considered oversold. The calculation formula for the Commodity Channel Index (CCI) is as follows:

   CCI = (TP - SMA) / (0.015 * MAD)

Here are the terms used in this formula:

  • TP (Typical Price): TP represents the typical price and is often calculated as follows: TP = (High Price + Low Price + Closing Price) / 3.
  • SMA (Simple Moving Average): SMA is the simple moving average of the typical price over a specific period. It is calculated by taking the sum of the typical prices over a given time frame and dividing it by the total number of time periods. For example, if you want to calculate a 20-period CCI, you would sum the last 20 typical prices and divide by 20.
  • MAD (Mean Absolute Deviation): MAD represents the sum of the absolute values of price changes above or below the moving average of the typical price. In other words, it measures how much each typical price deviates from the moving average when comparing the two.

The CCI indicator oscillates between 100 and -100 levels as a result of these calculations. A CCI value above 100 indicates overbought conditions, while a value below -100 indicates oversold conditions. Therefore, CCI is an indicator used to identify overbought and oversold conditions and potential reversals.

Trade with the Commodity Channel Index (CCI)

We use the Commodity Channel Index (CCI) to analyze price movements on a given timeframe and identify possible trading signals. Different strategies can be developed to generate buy and sell signals with the CCI. Let's look at two of the most common strategies:

Turning Signals from Overbought and Oversold Zones. When CCI rises above 100 and then reverses, it can be a sell signal. This suggests that a reversal or pullback may occur after overbought conditions. If CCI reaches -100 or lower and then the downward trend reverses, it can be considered a buy signal. This indicates a possible reversal after oversold conditions. See the example on the daily chart of Natural Gas below:

This chart shows an example of how the CCI indicator can be used to identify a reversal signal. The CCI indicator reached an overbought condition in early January, and then reversed course and began to fall. This signaled that the uptrend was about to end, and the price of natural gas began to decline.
CCI trading Natural Gas daily chart example

Divergence Analysis. Monitoring divergences between CCI and prices can also assist in generating buy and sell signals. For instance, if CCI is rising while prices are falling, this can be interpreted as a positive divergence and a buy signal. Conversely, if CCI is falling while prices are rising, this can be seen as a negative divergence and a sell signal. See the example on the 4-hour chart of Brent Oil below:

CCI trading in Brent Oil 4-Hour Chart Example of Positive and Negative Divergences
Trading Opportunities Using CCI Divergences

Please note that trading in financial markets carries risks. It's important to maintain emotional control during trading. Avoid making hasty decisions and refrain from emotional-based trades. Like all other technical indicators, the CCI indicator has limitations and can produce false signals. CCI should not be used as a standalone trading strategy. Consider other technical analysis indicators, candlestick patterns, support and resistance levels, and combine CCI with them to obtain more reliable results.

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