The Commodity Channel Index (CCI) measures variation between an assets current price, and its average price. Don’t let the “commodity” part of the name mislead you; the indicator can be used for trading other markets, not just commodities. As with all trading indicators, I don’t advocate using it to generate trade signals on its own. Look at the overall price trend first, and then look to the indicator for confirmation or trade signals that align with the trend. By doing this you’ll avoid many of the false signals that the indicator (all indicators) generates. Here’s how the CCI works, and how to use it for trading.
The CCI measures how far above or below the current price is from its statistical average. The indicator typically fluctuates between -100 and +100; when the value is greater than +100 the price is considered high relative to the average price, when the value is lower than -100 the price is considered low relative to the average. Traders will often refer to the regions above +100 and below -100 as being “overbought” and “oversold.”
The “average price” is calculated over 14 periods (default indicator setting), but this can be adjusted slightly based on your market and strategies.
The CCI can be used all time frames, from 1 minute to monthly charts.
Figure 1. GBP/JPY 15 Minute Chart with CCI Indicator
Using the terms overbought and oversold is misleading though. Novice traders typically want to go short/buy puts when the indicators enters overbought territory, and go long/buy calls when the indicator is in overbought territory. Do this though and you’ll likely drain your account; I prefer the following method.
The main problem with just looking at overbought and oversold levels is that the trend is not considered. Consider a strong uptrend; during a strong uptrend you will get lots over overbought readings because the price is climbing, continually moving above the historic average price. Yet, if you go short (buy puts) based on the overbought reading, you’re fighting the trend. The price may pullback temporarily, but the trend will often resume and you’ll likely be left with a string of losing trades.
Instead, use the indicator in conjunction with the trend. Watch for oversold readings during an overall uptrend to signal a potential buying (call) opportunity. Watch for overbought readings during an overall downtrend to signal a potential shorting (put) opportunity.
Figure 2. Look for Overbought Levels During Downtrend
In figure 2 I have drawn a trendline to show the trend is down. You may also choose to add a moving average to your chart, or draw support and resistance levels to help see the trend.
Figure 3. Oversold During Uptrend
Figure 3 has a 50-period moving average, and I have also drawn horizontal lines showing where I expected support to develop. As the price pulls back toward the moving average and price support region, the indicator enters oversold territory. As the price begins to rise again there is an opportunity to go long (buy call) will minimal risk.
To help improve timing, I prefer to enter trades once the CCI moves back above -100 (for buy/call trades in uptrends) or back below +100 (for short/put trades in downtrends). So in Figure 3, you’d hold off on taking the long trade until the CCI moved back above -100.
A drawback of this strategy is that you may not get a trade signal if the trend is very strong. For example, during a surge higher, the price may not pullback far enough to create an oversold reading on the indicator. If you rely solely on the indicator for your trade signals you may miss out on a high profit/high probability move.
No strategy is perfect though, so if you like the strategy stick to it, and don’t worry about the trades you may miss.
Also, if you just look for overbought and oversold levels in uptrends and downtrends, your trade entry timing may still be poor. This is because overbought and oversold can last for a long time. This drawback can be somewhat alleviated by adhering to the timing guideline above: enter trades once the CCI moves back above -100 (for buy/call trades in uptrends) or back below +100 (for short/put trades in downtrends).
Use the CCI indicator in conjunction with trend analysis to isolate low risk trading opportunities. Watch for oversold levels on the CCI when the price is in an uptrend–these are buying opportunities. Watch for overbought levels on the CCI when the price is a downtrend–these are shorting opportunities. Use trendlines, moving averages or support and resistances to help determine the trend direction. Don’t be misled by labels such as “overbought” and “oversold,” because during a strong uptrend the market is almost always overbought, and during a strong downtrend, always oversold. Finally no strategy is perfect, but it doesn’t have to be. If you like the strategy, try it out on a demo account until you are comfortable spotting trades and making a profit, only then should you utilize it using real funds.