The Commodity Channel Index, or CCI, is an oscillating indicator that investors can use
to identify potential entry and exit signals.
The CCI was originally applied in the commodity market, hence the name, but is now commonly
used for all securities.
The CCI measures the relationship between the price of a security and its moving average.
A moving average of any length can be used with the CCI, but a 20-day moving average
is common.
The indicator plots the difference between the price of a security and its moving average.
The indicator is plotted around three horizontal lines that form a channel.
One channel line is set at zero, another at -100, and the third at +100.
The CCI is calculated so that approximately 70 to 80% of price movements fall between
-100 and +100.
If the price moves above the moving average, the CCI line is above zero.
If it crosses below the moving average, the CCI falls below zero.
However, when price deviates significantly from the moving average, the CCI line crosses
outside the outer channel lines, and the underlying security could be considered overbought or
oversold.
Some investors might use the various crosses of the channel lines to help identify potential
entry and exit signals.
For example, if the CCI drops below the -100 line and then crosses back above it, an investor
might see this as a potential entry signal.
Conversely, if the CCI rises above the +100 line and then crosses back below it, an investor
might see this as a potential exit signal.
Other signals arise from divergences between the price of an underlying security and an
overbought or oversold CCI.
A bullish divergence occurs when the price of a security falls to a lower level, but the
level of the oversold CCI holds up at a higher low.
This can indicate selling pressure is weakening and the security might be expected to reverse
higher, signaling a potential entry signal.
Confirmation of a bullish divergence occurs when the CCI rises back above the -100 channel
line.
A bearish divergence occurs when the price of a security rises to a higher high, but
the level of the overbought CCI plateaus at a lower high.
This can indicate that buying is subsiding and that the security might be about to reverse
lower, signaling a potential exit signal.
Confirmation of a bearish divergence occurs when the CCI falls back below the +100 channel
line.
Whether using divergences or channel line crosses, the primary benefit of using CCI is
to help time entry and exit signals.
But the indicator can also serve as a filter for other common entry signals.
For example, a CCI above the +100 channel line could indicate that a security is overbought
and might be at risk of reversing lower.
So, an investor might decide to avoid entering the trade.
Keep in mind that the CCI, like other indicators, is not a guarantee that the price of a security
will change.
Let's consider the risks.
As with other oscillating indicators, one risk of using the CCI is that a security can
remain overbought or oversold for long periods of time.
These stretches can be filled with channel line crosses, and even divergences, that convey
false signals and fail to deliver the expected results.
Another risk is news announcements.
Big events like earnings can, and often do, override signals from the CCI, so it's important
to be aware of announcements and headlines.
Sure, the CCI can provide context to trends, be used to identify divergences, and even
help with timing of potential entry and exit signals.
But investors should understand that many factors influence the price of a security.
Traders often combine oscillating indicators, like CCI, with trending indicators, like a
moving average.
Many include fundamental analysis as well.