Finschool By 5paisa

# Commodity Channel Index (CCI) Indicator

By News Canvass | Oct 26, 2023

The complete form of the CCI Indicator is the Commodity Channel Index, an essential tool for traders and investors. This indicator assists in analyzing and predicting market trends, making it a valuable asset in finance.

## What is the Commodity Channel Index (CCI)?

The Commodity Channel Index, often called CCI, is a technical indicator used to assess the momentum of financial instruments. It measures the relationship between the current price, its average over a specific period, and its standard deviation. CCI helps traders identify overbought or oversold conditions and potential trend reversals by comparing the current price level with its historical average.

## Working of Commodity Channel Index

The Commodity Channel Index quantifies the deviation of asset’s price from its statistical mean. It operates within a range, typically -100 to +100, where values above +100 suggest that the asset is overbought, and values below -100 indicate oversold conditions. CCI’s calculation considers three main components: the typical price, the mean deviation , and the moving average.

Formula

CCI is calculated using the following formula:

CCI = (Typical Price−SMA)​ / (0.015×Mean deviation)

Where:

• Typical Price = (High + Low + Close) / 3
• SMA = Simple Moving Average of Typical Prices
• Mean deviation = Mean Deviation of Typical Prices

## Calculation of Commodity Channel Index

The CCI is typically plotted on a chart with a range of -100 to +100. CCI reading above +100 indicates that the security is overbought, while a reading below -100 indicates that the security is oversold.

Here are the steps on how to calculate the CCI manually:

1. Gather the historical price data for the security you want to analyze.
2. Calculate the Typical Price for each period.
3. Calculate the Moving Average of Typical Price for the specified period of time.
4. Calculate the Mean Absolute Deviation of Typical Price for the specified period of time.
5. Calculate the CCI for each period using the formula above.

You can also use a financial calculator or trading software to calculate the CCI.

Here are some of the factors to consider when using the CCI:

• The length of the period used to calculate the CCI. The shorter the period, the more sensitive the CCI will be to changes in price.
• The volatility of the security. The more volatile the security, the higher the CCI readings will be.
• The trend of security. The CCI is more likely to generate buy signals when the security is in an uptrend and sell signals when the security is in a downtrend.

## Advantages of the Commodity Channel Index

The Commodity Channel Index is technical indicator with several benefits. These include:

• It can be used to identify oversold and overbought
•  conditions.
• It can be used to identify trend reversals.
• It can be used to identify trading opportunities.
• It is relatively easy to use and understand.
• It can be used with other technical indicators to improve its accuracy.

Here are some of the specific benefits of using the CCI:

• Identifying overbought and oversold conditions: The CCI can identify oversold and overbought conditions, which can be used as signals to sell or buy a security. When the CCI is above +100, the security is considered overbought and may be due for correction. When the CCI exceeds -100, the security is considered oversold and may be scheduled for rebound.
• Identifying trend reversals: The CCI can also identify trend reversals. When the CCI crosses above +100, it can signal that a bullish trend is underway. When the CCI crosses below -100, it can signal that a bearish trend is underway.
• Relatively easy to use and understand: The CCI is relatively easy to use and understand, even for beginner traders. It is also a relatively inexpensive indicator to use.
• Can be used with other technical indicators: The CCI can be used with other technical indicators to improve its accuracy. For example, the CCI can be used with the moving average to identify trend changes.

## Using Commodity Channel Index

Here are some of the specific guidelines for using the CCI:

• Typical Price: The typical price is calculated by taking the average of the High, Low, and Close prices for a specified period of time. The most common period used is 20 days.
• Moving Average of Typical Price: The average of the typical price is calculated by taking the simple moving average of the typical price for the specified period. The most common period used is 20 days.
• Mean Absolute Deviation of Typical Price: The mean absolute deviation of the typical price is calculated by taking the average of the absolute deviations of the typical price from the moving average of the typical price. The most common period used is 20 days.
• Overbought: The CCI is considered overbought when it is above +100.
• Oversold: The CCI is considered oversold when it is below -100.
• Buy signal: When the CCI crosses above -100, a buy signal is generated.
• Sell signal: A sell signal is generated when the CCI exceeds +100.

## Overbought and Oversold Levels

Overbought and oversold levels indicate extremes in the market sentiment. When CCI surpasses +100, it suggests that the price has risen significantly and may be due for a correction. Conversely, CCI falling below -100 indicates that the price has declined considerably and might rebound soon.

CCI Divergence

CCI divergence occurs when the indicator’s direction diverges from the price trend. Bullish divergence happens when CCI forms higher lows while the price forms lower lows, potentially signaling an uptrend. Bearish divergence, on the other hand, occurs when CCI forms lower highs while the price includes higher highs, indicating a possible downtrend.

CCI Trend Line Breaks

Trend line breaks using CCI involve drawing trend lines on the indicator itself. A break above the upper trend line suggests a potential uptrend continuation, while a break below the lower line indicates a possible downtrend continuation.

## Things to keep in mind

Some of the things to know about the working of the Commodity Channel Index strategy:

• The CCI is a lagging indicator that does not provide early signals of price movements.
• It can be sensitive to volatility.
• It can generate false signals.
• Using the CCI in conjunction with other technical indicators and fundamental analysis is essential to make trading decisions.

Here are some additional tips for using the CCI strategy:

• Use the CCI in conjunction with other technical indicators. This will help you to confirm signals and reduce the risk of false alerts.
• Use the CCI with different time frames. This will help you to identify trends and trading opportunities in different time frames.
• Adjust the settings of the CCI to suit your trading style and preferences.
• Backtest the CCI on historical data to see how it has performed. This will help you better understand how the CCI can be used to generate trading signals.

## Difference Between the Commodity Channel Index vs. the Stochastic Oscillator

The Commodity Channel Index (CCI) and the Stochastic Oscillator are both momentum indicators that can identify overbought and oversold conditions, trend reversals, and trading opportunities. However, there are some critical differences between the two indicators.

• Calculation: The CCI is calculated by comparing the current price of a security to its average price over a specified period of time. The Stochastic Oscillator is calculated comparing closing price of security to its price range over specified period of time.
• Range: The CCI has a range of -100 to +100. The Stochastic Oscillator has a range of 0 to 100.
• Signals: The CCI typically identifies overbought and oversold conditions. The Stochastic Oscillator is typically used to identify oversold and overbought conditions and trend reversals.
• Sensitivity: The CCI is more sensitive to price changes than the Stochastic Oscillator.
• Lagging: Both the CCI and the Stochastic Oscillator are lagging indicators, meaning they do not provide early signals of price movements.

## Drawbacks of Using the Commodity Channel Index

• Lagging indicator: The CCI is a lagging indicator that does not provide early signals of price movements. This means the CCI will only signal a trend after it has begun. As a result, the CCI can be less effective for identifying trading opportunities.
• Sensitive to volatility: The CCI is sensitive to volatility, which can generate more false signals in volatile markets. This is because the CCI is based on the average price of security over specified period of time. The average cost can fluctuate when the market is volatile, leading to more false signals from the CCI.
• Generates false signals: The CCI can generate false signals, meaning that it can signal a trend that does not occur. The CCI is based on historical price data, and the future is only sometimes predictable. As a result, it is vital to use the CCI in conjunction with other technical indicators and fundamental analysis to reduce risk of false signals.
• Settings of the CCI can be subjective: The settings of the CCI can be subjective, meaning that different traders may use other locations. This makes it difficult to compare results of the CCI across different traders.
• Not consistently effective in all markets: The CCI is only sometimes effective in all markets. For example, the CCI may be less effective in less liquid markets than others. As a result, it is vital to backtest the CCI on historical data for the specific market you are trading to see how it has performed in the past.

Despite these limitations, the CCI can be a helpful technical indicator when used correctly. It is essential to be aware of the CCI’s limitations and use it in conjunction with other technical indicators and fundamental analysis to make trading decisions.

## Conclusion

The Commodity Channel Index (CCI) is a versatile tool that empowers traders to make informed decisions about market trends, entry and exit points, and potential reversals. By understanding how CCI works, calculating it, and interpreting its signals, traders can enhance their trading strategies and achieve tremendous success in the dynamic world of finance.