The Commodity Channel Index (CCI) shows when a price is high or low compared to its statistical average. The CCI is interpreted in the following ways:
- A price correction is likely when the price hits new highs and the CCI doesn’t
- The market is overbought and may experience a correction if the CCI is above 100
- The market is oversold and may experience a correction if the CCI is below 100
Note that the CCI indicator was originally developed for trading commodities, but now it’s used in many types of trading, including forex.
The Commodity Channel Index (CCI) was invented by Donald Lambert in 1980. It is one of the indicators that is classified as a momentum indicator; indicating the strength of a particular trend in a currency pair. In other words, it tells the trader if the ongoing trend is still strong (in which case continuation is likely) or weak (in which case, a reversal is possible in the near-term).
Retail traders can use the Commodity Channel Index indicator in two main ways as will be demonstrated in this article.
Using CCI in Technical Analysis
For the purpose of this discussion, retail traders can make use of the Commodity Channel Index (CCI) when conducting technical analysis in two ways:
- The Commodity Channel Index indicator can function just as the MACD indicator by pointing out areas where there is a divergence between the highs and lows of the currency pair and the highs and lows of the CI indicator line. Since the price of the currency pair will eventually correct itself to follow the direction of the CCI indicator, such a divergence can form the basis of a trade.
- Since the CCI has been identified as a momentum indicator that is capable of determining the possible points of reversal, it can also be used to indicate areas where the currency pair is overbought and therefore ready for sellers to push prices down, or oversold and ready for re-entry of buyers.
The CCI indicator is one of the default indicators that are found on the MT4 platform. In order to apply this indicator to the charts, open the currency chart on which the CCI is to be used, then click on Insert –> Indicators –> Oscillator –> Commodity Channel Indicator.
Once you have done this, adjust the thickness of the signal line from the input parameters and you are good to go.
1) Use of CCI as an Oversold/Overbought Indicator
When we look at the CCI indicator window, it can be seen that just like the other oversold/overbought indicators (e.g. Stochs oscillator), the indicator window has a marked calibration that has negative and positive ends of the spectrum, with a 0 line in between. When the currency pair is at a CCI level that is close to + 500 (which is the positive end of the spectrum), this shows that the asset is overweight/overbought. When the CCI is closer to -500, the asset is underweight with buyers waiting in the wings and ready to push the asset upwards. The key levels are between +100 to +500 for overbought scenarios and -100 to -500 for oversold scenarios.
Therefore, when the CCI has started to curve downwards from an overbought area, it is an indication to sell. When the CCI has started to curve upwards from an oversold area, it is an indication to go long on the currency pair.
Therefore, at least two parameters must be fulfilled when trading with the CCI as an oversold/overbought indicator.
Long Entry Signal
- CCI is below -100. The more negative the value of the CCI (or the closer the CCI is to -500), the stronger the signal.
- CCI has started to curve upwards.
Short Entry Signal
- CCI is above + 100. The nearer the CCI is to +500, the more likely that the asset is overbought and will be sold off shortly.
- CCI has started to turn downwards.
These signals on their own only give an indication of what the trader should do with the currency pair. They are not iron-clad signals. They must, therefore, be traded with confirmation from any of the following:
a) Overbought signals from the CCI must be supported by either a bearish candlestick reversal pattern, or price action retreating from a strong resistance area, which could either be a resistance pivot line, an upper trendline within a bearish reversal chart pattern such as a rising wedge or an area where upward movement of price has been resisted in the recent past. We see an example here:
This chart shows that the CCI is heavily overbought at the same time that the currency pair is at a resistance area. The resistance area is well defined because if we look back, we see that there have been previous attempts to breach this resistance and the asset could not get above that area.
b) Oversold signals from the CCI must also be supported by either a bullish candlestick reversal pattern, or price action bouncing up from a strong support area, which could either be a support pivot line, a lower trendline within a bullish reversal chart pattern such as a falling wedge or an area where downward movement of price has been taken a bounce in the recent past. We see an example of this here:
This chart shows the use of a falling wedge, which is a chart pattern that shows an impending bullish reversal price bouncing off the lower trend line on its way to a bullish breakout at the same time that the CCI was oversold and had started to turn upwards.
2) Use of CCI in Divergence Trading
CCI can also be used for divergence trading. The CCI closely mirrors the movement of the price of the currency pair. This point must be noted carefully because it is what makes a divergence a tradable signal. There is a divergence situation when the price of the asset is not mirroring the movement of the CCI.
The divergence could be a negative divergence (which produces a signal to short the currency pair) or a positive divergence (which produces a signal to buy the currency pair). The two situations are demonstrated below.
a) Negative Divergence
In a situation where there is a negative divergence, the CCI indicator deviates from the currency pair’s movements in a downward direction. In other words, the price is making higher highs at the same time that the CCI is making lower highs.
In this scenario, the currency pair was making higher highs when the CCI was making lower highs. The rule is that the currency pair will correct its movement in the direction of the CCI indicator. Moreover, the prevailing trend was actually a downtrend, which provided the bias for the downside correction of the currency pair in the direction of the prevailing trend.
As a rule, look for a technical indication on where to enter the trade. In this chart, a pin bar formed at the area of the 2nd price high (the higher high), and this provided the impetus for the lowering of the price of the asset. The correct place to enter the signal would, therefore, be on at the open of the candle following the pin bar.
b) Positive Divergence
There are also instances to trade a positive divergence. We see this when the currency pair is making lower lows and the CCI is making higher lows. Again, the bias for the trade is for the asset to correct itself in the direction of the CCI’s movement as we see in the chart below:
The CCI is a very powerful indicator that can produce useful signals when used properly. It is able to show tradable signals when used as an overbought/oversold indicator and when used for divergence trading. Practice with this lesser-known indicator and announce yourself in the world of successful forex traders
To calculate the CCI, the typical price (TP) is calculated for the interval first. This is the average of the high, low and closing prices.
TP = ( HIGH + LOW + CLOSE ) / 3
The difference (D) between the simple moving average (SMA) price and the typical price is then calculated.
D = TP – SMA( TP, N )
N is the number of intervals used for the simple moving average
The CCI is then calculated by dividing the simple moving average of D by the value of D and then multiplying by a scaling factor.
CCI = SMA( D, N ) / D * 0.015