Since its introduction in 1980 the commodity channel index has grown in popularity, and is now used not only in commodities, but also in equities and currencies.
One of the disadvantages of oscillators such as the momentum is the absence of an upper and lower boundary. One of the biggest advantages of an oscillator is to allow for an interpretation on whether the market is currently too overbought or oversold. With the momentum, this is only possible by a vague historical interpretation that hardly allows a trader to generate trading signals.
The commodity channel index, sometimes also known as CCI, solves this problem. The CCI compares the current price with a moving average over a selected period of time and then divides it by the mean deviation. To generate more readable numbers, the result is then divided by 0.015.
While this procedure might seem complicated at first, it allows a trader to quickly evaluate how far prices have moved from their statistical mean. By using the inverse factor of 0.015, 70 to 80 percent of the CCI’s readings will be in the range from +100 to -100. Any value over +100 indicates prices that have moved far higher than their statistical mean. Vice versa, any value below -100 indicates prices that have moved far lower than their statistical mean.
The inventor of the CCI, Donald Lambert, originally recommended traders to invest in long positions for markets with a value over +100 and in short positions for markets with a value below -100. In his view, strong up- and downtrends that exceed these boundaries were good investment opportunities.
Over time, however, the use of the CCI has somewhat changed. Today, most traders use it as an indicator for overbought and oversold markets, and see it as a sign of an impending reversal. Readings over +100 are considered overbought, readings below 100 are considered oversold.
The CCI can be used in three ways to generate trading signals:
1: When the indicator leaves overbought or oversold levels:
When the CCI’s line falls below +100, this can be used as a signal to invest in falling prices. When the CCI’s line rises above -100, this can be used as a signal to invest in rising prices. You can trade these signals with High / Low options, or No Touch options in the opposite direction of the signal.
2: Breaking of the CCI’s trend line:
The line created by the CCI can also move in trends. If this trend’s trend line is broken, it can be considered a trading signal in the opposite direction of the trend. If the CCI was in an uptrend, the breaking of the trend line would generate a bearish signal. In a downtrend the breaking of the trend line would generate a bullish signal. You can trade these signals with High / Low options or a No Touch option.
3: Increase the quality of your signals:
By dividing the market into periods of overheated prices and normal prices, the CCI generates two different market environments. Depending on your strategy, one of these environments might be more suitable for your trading style. To eliminate losing trades and increase the quality of your signals, you can therefore add the CCI to your existing trading strategy. The idea is to only trade in market that are either out- or inside the CCI’s boundary.
While the CCI is most commonly used over a time period of 20 periods, it is important to note that the time period used for the calculation of the CCI influences the indicators tendency to move beyond its boundaries at +100 and -100. The shorter the time period, the more time the indicator will give readings over +100 or -100 and the more trading signals it will generate. By expending the time frame used for the calculation of the CCI, risk-averse trader can try to minimize false signals and maximize the percentage of winning trades.