Commodity Channel Index (CCI)
Commodity Channel Index (CCI) was originated by Donald Lambert in 1980. It is based on the assumption that a perfectly cyclical commodity price approximates a sine wave. Designed to be used with instruments, which have seasonal or cyclical tendencies, Commodity Channel Index is not used to calculate cycle lengths but rather to indicate that a cycle trend is beginning.
The most common uses of Commodity Channel Index are to:
- Indicate breakouts
This is Lambertís original interpretation, buying when the Commodity Channel Index moved above +100 and selling when the Commodity Channel Index went below -100. Lambert would exit the trade once the Commodity Channel Index moved back within the -100 to +100 bands. The assumption with this use of Commodity Channel Index is that once an instrument breaks +100 or -100 it has begun to trend.
- Generate buy and sell signals
Sell signals are when the CCI moves from above +100 to below +100 and buy signals are when the CCI moves from below -100 to above -100. This method works best when the market is non-trending.
- Indicate Bullish and Bearish Divergence
In trending markets the Commodity Channel Index can be used to indicate that the trend is weakening by signaling divergence. Divergence between the CCI line and the price indicates that an up or down move is weakening.
Bearish Divergence occurs when prices are making higher highs but the CCI is making lower highs. This is a sign that the up move is weakening.
Bullish Divergence occurs when prices are making lower lows but the CCI is making higher lows. This is a sign that the down move is weakening.
It is important to note that although Divergences indicate a weakening trend they do not in themselves indicate that the trend has reversed. The confirmation or signal that the trend has reversed must come from price action, for example when prices break a trend line.
Observation period: (default 5)
The choice of observation period is important. If the Commodity Channel Index is to be used as Lambert originally suggested then the Observation Period should be one third of the cycle length.
If the Commodity Channel Index is to be used for purposes other than in relation to cycles, the Observation Period can be set so that the -100 to +100 bands contain 70% to 80% of the data.