Commodity Channel Index (CCI)

Commodity Channel Index (CCI) is a useful addition to any trader’s toolkit. We examine how it helps to inform trades by highlighting price deviations.

  1. Defining the CCI Mathematically

  2. Working Out What the Commodity Channel Index is Saying

  3. Use the CCI With Other Indicators

  4. Limitations and Shortcomings

 

The Commodity Channel Index (CCI) relates the amount of divergence of how much an asset is worth to its statistical average, and this allows traders to pinpoint new recurrent conditions or trends.

This tool was created in 1980, for commodities trading, which is an asset class that by its very nature tends to cycle, but it’s gone on to enjoy much wider use with other kinds of investment as well. 

Defining the CCI Mathematically

The Commodity Channel Index looks at how much an asset value deviates from its statistical average. To work this out it takes the TP, the “typical price” of the commodity, taking away its simple moving average amount over the same period (for instance, average typical price, or ATP), then the outcome is divided by the mean absolute deviation (MAD) of the typical price.

This amount is multiplied by 66.67 (or 1/0.015) to ensure the Commodity Channel Index value is easier to read. This approach ensures that around three-quarters of the values tend to sit in the region of +100 and -100.

Commodity Channel Index (CCI) = (TP – ATP) / (0.015 x MAD)

The usual price will be what you get when you add its high, low, and close prices together for any specific period and divide them by three.

Mean absolute deviation is a way of finding variations in a set of data. It’s the average gap between data points and the mean of the set of data.

Working Out What the Commodity Channel Index is Saying

In its role as an oscillator, the commodity channel index gives traders a chance to get a handle on the potency of a trend and home in on excessive deviations in price. The way that traders use it is of course up to them, but when the CCI strays beyond the +100 to -100 region some see this as evidence of excessive deviations in price and it will prompt them to start looking for reversals in price in those areas. 

Other traders might see it differently though, perhaps considering that a Commodity Channel Index of more than +100 may be pointing towards a potential breakout and opting to trade with the trend until the CCI dips back under +100 again. In a similar way, a CCI that drops under -100 might be taken as an indicator of a potent downtrend, which would highlight the need for a short position.

This is a chart for WTI Oil, delineated on a weekly basis, where we can see a few instances (look for the vertical lines) of the Commodity Channel Index rising north of +100 and dipping under -100. The first vertical white line is telling us that here is the start of a hypothetical trade and the vertical line afterwards is telling us that we have come to the end of it.

For a trader who treats the CCI as if it’s purely an oscillator – which essentially means that it becomes a price reversal indicator – we might see trades that run against the grain of what it shows. So, a signal potentially suggesting to go short could be produced when the CCI is over +100 with a long recommended when it’s passed -100. A trader who sees the Commodity Channel Index as a trend/breakout tool might strongly prefer long trades when in the +100 CCI zone and short trades when it’s in the -100 CCI arena.

None of them would have worked for the trader who favours reversal of price. Testing this approach after-the-fact reveals that it doesn’t have much going for it. You’d be better off tightening up your approach by moving your scope of interest to +150 or below -150 or even above/below +200/-200.

If you want to follow trends with the Commodity Channel Index, it seems to be pretty good at working with lots of different assets, and that’s where you’d want to be testing it too. But not only that, you’d also want to try it out under different market conditions, and for different durations too.

Use the CCI With Other Indicators

You don’t just have to use the CCI on its own, you can use it with other indicators or oscillators too for a broader view that may yield other potential opportunities. 

For instance, you could run it alongside the Aroon oscillator, enabling the generation of trading signals going in the same way as the most significant trend, the idea being that two confirmations of the trend is better than one.

Here’s a ‘for instance’ using a weekly chart for oil:

  1. CCI (100-period) of above +100 for buy/long signals or below -100 for short/sell signals

  2. Aroon oscillator of above +75 for buy/long signals or below -75 for short/sell signals

Under these conditions the first two trades would have been buys, and the next one would have been a sell. The last trade would have been a buy that is still open.

Limitations and Shortcomings

Remember that you shouldn’t ever use any indicator on its own. The ones that take price and volume information and modify them using math will lag the price itself because they include a lot of prior information. Always use the Commodity Channel Index in conjunction with other tools. It can tell you that an asset price may be diverging from its historical average, but it can’t tell you why, and there could be perfectly good reasons. 

Using the CCI as a price reversal indicator, this change might look like one that can’t be sustained, but prices of assets don’t always go back to their average.

The actions of other traders can drive a trend, which is why following them is so prevalent in technical analysis.

Momentum-based oscillators look at things differently. They might see a +100 as a sign that there’s plenty of buying potential rather than a sign of over buying.

Over +100 and under -100 might point to over buying and overselling but can’t be taken as confirmation that a price will snap back to its usual groove. About three quarters of the CCI’s readings will sit within these tramlines, which means that for around ¼ of the time you’ll be getting possible trade signals. Don’t take these as gospel though, use other indicators to help verify each new signal.