The Stock Stethoscope

The Commodity Channel Index (CCI) is a technical analysis indicator that helps traders to identify overbought and oversold market conditions, trend reversals, and price divergences. The indicator was developed by Donald Lambert in the late 1970s as a tool to identify cyclical trends in commodity markets, but it is now widely used in all financial markets, including stocks, bonds, currencies, and cryptocurrencies.

The CCI measures the difference between the current price and its average over a specified period of time, and then it normalizes the result by dividing it by the mean absolute deviation (MAD) of the typical price (average of high, low, and close) over the same period. The formula for CCI is:

CCI = (Typical Price – SMA of Typical Price) / (0.015 x MAD of Typical Price)

Where:

Typical Price = (High + Low + Close) / 3
SMA = Simple Moving Average
MAD = Mean Absolute Deviation
The CCI oscillates around a zero line, with positive values indicating that the price is above its average and negative values indicating that the price is below its average. The indicator is often used with a default period of 20, but traders can adjust the period based on their trading style and market conditions.

Traders can use the CCI in several ways, When the CCI moves above +100, it indicates that the price is overbought, and when it moves below -100, it indicates that the price is oversold. Traders can use these levels as signals to enter or exit a trade, or to adjust their risk management strategies.

When the CCI changes direction from positive to negative or from negative to positive, it can signal a potential trend reversal. Traders can use this signal to anticipate a change in market direction and adjust their trading strategies accordingly.
When the price of an asset makes a new high or low, but the CCI fails to confirm the move, it can indicate a divergence between price and momentum. Traders can use this signal to anticipate a potential trend reversal or a correction.

The best settings for the CCI depend on the trader’s preference and the market conditions. Generally, a shorter period (e.g., 14 or 10) can generate more signals but may be more prone to false signals, while a longer period (e.g., 30 or 50) can filter out noise but may lag behind the price action. Traders can experiment with different periods and adjust the levels of overbought/oversold based on their trading style.

The CCI can be used in combination with other indicators, such as moving averages, trendlines, or momentum indicators, to confirm or filter signals. For example, traders can use a moving average crossover as a trend filter for CCI signals, or they can use the Relative Strength Index (RSI) to confirm oversold/overbought conditions.

Here are two examples of how different categories of traders can use the CCI:

A) Swing traders can use the CCI to identify potential trend reversals or corrections in the short term. They can enter a trade when the CCI signals a change in direction and exit when the price reaches a resistance or support level.

B) Day traders: Day traders can use the CCI to identify overbought/oversold conditions in the intraday timeframes. They can scalp small profits by entering and exiting trades based on the CCI levels and the price action.