What is it?
The Commodity Channel Index (CCI) is a leading oscillating cycle and momentum indicator that was developed by Donald Lambert to identify cyclical turns in commodities but can also be used on securities and bonds as well. The CCI is a comparison of the typical price (TP) and a simple moving average (SMA) of the typical price (SMATP) and is expressed as an oscillating percentage that can exceed -100% and 100%. It can be used to predict a price reversal, and to determine overbought or oversold conditions.
How is it calculated?
As the CCI is based on the assumption that commodities, securities, and bonds move in cycles, with highs and lows being reached at periodic intervals, it is recommended that you use a third (⅓) of a complete cycle from low to low or high to high as the time frame for the CCI. Thus, if the takes 60 periods to complete, then a 20-period CCI would be recommended. Once you have determined the time frame for the CCI, you can calculate the CCI in four steps:
First, calculate the last period's Typical Price (TP) which is:
( H + L + C ) / 3
where H = high, L = low, and C = close.
Seconds, calculate the Simple Moving Average of the TP (SMATP) for the period of the CCI (i.e., 20 periods for a 20-period CCI).
Third, calculate the Mean Deviation which is the sum of the difference between the last period's SMATP and the typical price for each period of the CCI periods divided by the number of periods.
Finally, calculate the CCI using the formula:
CCI = ( TP - SMATP ) / ( 0.015 x Mean Deviation )
How is it used?
Lambert used the CCI to generate entry and exit signals when the CCI moved above +100% and below -100% respectively. When the CCI moves above +100%, the security enters into a strong uptrend and an entry signal is given. When the CCI moves back below +100% this position should be closed. Conversely, when the CCI moves below -100%, the security enters into a strong downtrend and an exit signal is given. When the CCI moves back above -100% this position should be closed.
In addition, an entry signal is given when the CCI bounces off of the zero line. When the CCI reaches the zero line, the security's average price is at the moving average used to calculate the CCI and when a security bounces off its moving average it is considered a good entry position as the security has pulled back to its short-term support with the bounce reaffirming the current trend.
The CCI can also be used to identify overbought and oversold levels. A security could be considered oversold when the CCI moves below -100 and overbought when it moves above +100. From an oversold level, an entry signal may be given when the CCI moves above -100. From an overbought level, an exit signal might be given when the CCI moves below +100.
Divergences can also be applied to the CCI. A positive divergence below -100 would increase the probability of a signal based on a move above -100, and a negative divergence above +100 would increase the probability of a signal based on a move back below +100.
Trend line breaks can be used to generate entry and exit signals. Trend lines can be drawn connecting the peaks and troughs. From oversold levels, a move above -100 and a trend line breakout could be used as an entry signal. Conversely, from overbought levels, a move below +100 and a trend line breakout could be used as an exit signal.