Commodity Channel Index (CCI) Explained

Definition of the Commodity Channel Index (CCI)

The Commodity Channel Index (CCI) indicator was originally developed for the commodity markets by Don Lambert in 1980. It has however found use in other markets including the forex market. Generally speaking, CCI measures overbought and oversold levels of a currency pair because its value is high when prices have extended upwards above average, and CCI values are low when prices dip far below average.

Components of the CCI Indicator
The CCI is made up of the following components:

  • Overbought zone
  • Oversold zone
  • CCI Line

 

The direction of the CCI line shows the trend. If it moves up, the market is in an uptrend. If the CCI line is heading downwards, the market is bearish.

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The overbought/oversold zones are extremes of price action. They are seen in the CCI indicator window as the extreme areas, usually above 100 (overbought) and below -100 (oversold). Reversal of price action is possible at price extremes.

Indicator Settings

The indicator is listed on the MT4 among the Oscillator indicators. To attach it to the MT4 chart, click on Insert -> Indicators -> Oscillators -> Commodity Channel Index

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In terms of appearance, some modifications to the look of the indicator can be made. These modifications can be either to increase or reduce the line thickness of the individual moving averages or to change their colour to make them distinct from each other, especially when several moving averages are used.

Usage of the CCI in Forex Trading

The CCI is built as a channel which is calibrated from -100 to 100. When the CCI value rises above 100, the conventional strategy is to buy the currency pair and to hold the position until the CCI values start to drop below 100. The conventional short trade signal is taken when the value of the CCI drops below -100, and is held until CCI values start to rise above -100.

1) As an Overbought/Oversold Indicator

Experience has shown that using -100 and +100 as the extremes of CCI to measure oversold and overbought levels leads to a lot of inaccuracy. The boundaries that constitute these levels are not set in stone and are mostly left to the trader’s interpretation. Most platforms now set these levels at -150 for oversold conditions and 150 for overbought conditions.

Furthermore, this is not an absolute signal to trade. There will be many instances where price will continue higher in overbought conditions, or continue to drop in oversold conditions. Therefore the CCI should not be used as the sole indicator to pick out these conditions for trading. Supplementation with other indicators and even with candlestick or chart patterns is necessary.

2) Divergence Trading

The CCI lends itself very well to divergence trading. Divergences are areas where the peaks and troughs of price action do not conform to those of the indicator. A bullish divergence is seen where price makes a lower low but CCI forms a higher low. A bearish divergence is seen when price forms a higher high but CCI makes a lower high. In both cases, price is expected to correct the divergence in the indicator’s direction. Divergences must be confirmed, and trade entry points must have sound technical basis. A support or resistance break on the charts confirms a divergence trade.

Candlesticks and chart pattern breakouts will have the same effect. Yet a third way of confirming the divergence is to look at whether the CCI line has broken the zero mark, and in which direction such a break has occurred. The bullish divergence will see the CCI breaking the zero mark upwards, while a bearish divergence will see the CCI breaking the zero mark downwards.

Trade Example

We will demonstrate the divergence trade in our CCI trade example. In this snapshot, we see the CCI indicator forming higher lows while price action is forming lower lows. The divergence is a bullish divergence, since we expect price action to correct in the direction of the indicator.

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What happens? The bullish divergence trade held true. Confirmation is seen from CCI breaking the zero line upwards. However, the trigger for the trade entry was the formation of the bullish engulfing pattern, which is a strong bullish reversal candlestick pattern. The long entry for this setup is made at the open of the candle following the bullish engulfing pattern.

The exit point for the trade is when the CCI has hit the overbought area. The events that have been described can all be seen in the snapshot above.

Conclusion

It is essential that you practice how to trade each setup on a demo account before using the indicator to trade real money. Also pay attention to risk management.

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