How to use the Commodity Channel Index (CCI) indicator

It’s natural to think that an indicator called the commodity channel has something to do with commodities. So, if we’re trading forex, or stockmarkets, what does it have to do with us?

It measures one of the most fundamental truths about charting and price action, and there’s a good reason why so many pro traders have this sitting at the foot of their charts …

What’s it got to do with commodities?

The Commodity Channel Index (CCI) was developed in the 80s by Donald Lambert to identify cycles in commodities.

But it can be used in forex, indices, stocks … whatever market you like, because it measures a very basic fact about prices – most prices have a ‘norm’ and tend to move around either side of that ‘norm’.

The calculation behind it is a pretty simple one … it measures the typical price over a period (20 days usually), and measures how far the current price has deviated from that typical price.

The name for the principle behind this is mean reversion.

If you’ve been with Trader’s Bulletin for a while, and have followed my trading journey, you may already be familiar with the principles of mean reversion.

If not, I’ll give you a quick heads-up …

Mean reversion trading strategies are based on the idea that price highs and lows are temporary glitches and that price will tend to go back to its long-term average.

So, our mean-reversion trader will buy when the price looks like it’s deviated too far below its average. And he’ll sell when it looks like it’s deviated too far above its average.

It might come under different names, but mean reversion theory is all around us …

… when people tell us that we have a housing market bubble …

… when they tell us that gold is dirt cheap compared to it’s long-term correlation with some other price …

… and every time we wait for a dip in the price before we enter …

And if you’ve used Martin Carter’s Diff Code strategies (which grew out of his mean reversion system), you’ll know that he measures long-term correlation ‘norms’, and trades how prices deviate from these norms.

So, how do we use the CCI?

The CCI indicator is an oscillator that swings between over-bought and over-sold conditions at +100 and -100 respectively.

It’s easy to bunch all the oscillator indicators together – they’re all similar-looking wobbly lines at the foot of our charts … they all give over-bought/over-sold readings.

But, while RSI and Stochastics are looking at momentum, the CCI is measuring something subtly different – deviation.

However, there are some things it does have in common with other oscillators …

… prices can stay in over-bought and over-sold territory for some time before reverting back. And our oscillators can’t tell us how long these periods will be.

For that reason, using CCI (or any other oscillator for that matter) in isolation to sell over-bought markets or buy oversold markets, is a strategy doomed to failure.

There will be just too many false signals.

A better way to use CCI

The preferred way to use CCI is to look for divergence as a confirmation signal.

If you’re familiar with trading divergence in other oscillators, this will be dead simple for you. If not, I’ll explain here …

What we’re looking for is overbought or oversold territory, and for the price action to be in disagreement with the CCI.

What do I mean by that?

Simply that prices are going up, and CCI is going down. Or that prices are going down, but CCI is going up.

This gives us a warning that the current trend may have run its course – the price could be about to head back to its ‘mean’.

Here’s what it looks like in action …

This shouldn’t be used as a price trigger in itself, but when you’re looking for the perfect place to get into a trade, it can give you confirmation to press the button.

A hand on the fevered brow of the market

For me, CCI is a useful tool to have on your charts.

Personally, I don’t use it in a formal way, but it does give me an at-a-glance picture of market temperature – is it overheated or cooling off?

If you use this indicator in a different way, or have experiences you can share, please add your comments below.

And, finally, please remember to look out for my big reveal next week.

When you see my email on Wednesday, your first reaction might be that I’ve completely lost the plot … but please bear with me. This is going to be quite a revelation!

Until next week …

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