The Commodity Channel Index (CCI) is a technical indicator used by analysts and traders to identify irregular price action exhibited by a security. Classified as a momentum oscillator, the CCI was developed by mathematician Donald Lambert and introduced to the trading world in 1980.
The original goal of Lambert's CCI was to mitigate timing challenges attributed to entering cyclical or seasonal commodities markets. In order to accomplish this objective, he devised a method of comparing ongoing pricing fluctuations with those of the past. Through identifying the need for a current comparison of price and a mode of standardisation, Lambert was able to construct the CCI based upon the following tenets:
- Moving Average: A moving average is used as the benchmark to which current price behaviour is compared. This is done to preserve the relevance of the current price comparison and to eliminate any confusing "noise" attributed to the historical data set.
- Standardisation: Because financial instruments often move in unique intervals, a device is necessary to bring CCI values into alignment. Lambert decided on .015 as the optimal constant divisor value to be used in the CCI equation. The standardisation of the CCI using the .015 constant ensures that 70-80% of all calculations will fall between the established +100 or -100 range.
Originally, the CCI was developed solely for the purpose of trading seasonal commodities. However, as the popularity of the CCI grew, it was adapted for use in the trade of equities, currencies and futures products.
Advances in technology have made calculating the CCI automatic, which is a far cry from the tedious undertaking it was during the early days of the indicator. Software trading platforms typically include a form of the CCI as part of the public domain, offering its use to customers free of charge.
The formula for calculating the CCI is as follows:
CCI = ((Today's Typical Price-(MA)) / (.015*MD)
- Today's Typical Price = ⅓(High+Low+Close)
- MA = Moving average of N periods of recent typical prices
- .015 = Lambert's standard divisor
- MD = Mean deviation of N periods of recent typical prices
Statistical calculation of the CCI formula is complex, involving multifaceted computations of both the moving average (MA) and mean deviation (MD). However, it is important to remember that the actual derivation of the CCI is largely automated by the functionality of modern trading software. Individuals interested in experimenting with the actual calculation of the CCI can do so seamlessly through altering the periodicity of formula inputs within the trading software itself.
As stated previously, the CCI is used by market participants to identify situations where a security's price is behaving irregularly. Typically, irregular behaviour is associated with either being "overbought" or "oversold," based on the +100 to -100 defined range of CCI values.
Trading approaches view the CCI value eclipsing the +100 and -100 levels in distinct and often contrasting ways. Listed below are common methods of interpreting and applying the CCI to an active trading plan:
- Breakout: Capitalising on growing market momentum is one strategy that implements the CCI. For instance, in the event that the CCI value moves above the +100 level, then positive momentum is deemed to warrant taking a long position. Conversely, if the CCI falls below -100, then going short is the trade. Both positions are to be closed when the CCI returns to a value within the +100 and -100 channel.
- Market Reversal: The CCI may be used as a leading indicator, used to identify overbought and oversold conditions. Upon the CCI moving outside of the +100 and -100 channel, a contrarian position may be taken to capitalise on price's potential return to the normal CCI range.
- Continuation: Directional price action may be observed in concert with especially high or low CCI values. This may be viewed as evidence of a future extension in price and continuation of the current trend.
- Divergence: Divergence between current price action and CCI may be interpreted as indication that price is pending reversal or entering a compressional phase. For instance, if CCI is rising in tandem with price, but making lower highs over the course of a given period, then the bullish move in price may be viewed as weakening.
The CCI provides a method of viewing price action within the context of a market's normal behaviour. However, while the CCI is popular and valued by many, it is not infallible. As with many other tools and indicators, the CCI is best utilised within the framework of a comprehensive trading plan.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
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