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How does the Commodity Channel Index (CCI) indicator work?  

 

The Commodity Channel Index (CCI) is used to determine the overbought or oversold conditions in the market.

The CCI has been one of the most commonly used indicators for years in the commodity markets, and forex markets have warmed to it in recent years.

Commodities markets have a long history of liquid trading conditions, meaning traders can look back at past data to back test and see how it has performed over the years.

In fact, many traders around the world have used the CCI not only for commodities and forex, but for stocks and bonds as well.

Structure


The CCI indicator is an oscillator, meaning it measures the strength or weakness behind the market, and whether or not a trend is reliable.

The indicator has a center line for the ‘zero level’ that shows a neutral reading. The indicator shows up in its own window below the price chart, and it is bound by 100 points on both sides of that zero line.

The indicator line rising above the 100 level shows a potential overbought condition in a currency pair, while a move by the indicator line below the -100 level shows a potential oversold condition.

Between those two levels, it shows that the market has either positive or negative momentum, but it doesn’t provide an actionable signal in and of itself.

However, there are many ways to use the Commodity Channel Index, as we shall see.

The CCI indicator attached at the bottom of a chart
 
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Calculating the CCI


The Commodity Channel Index has been around for a few decades, becoming much more widely used as computing power became reasonably priced.

Developed in 1980 by commodities trader Donald R Lambert, it is more complicated than most older indicators.

This is because it was developed in an era when computers’ processing power was growing, meaning more mathematically complex equations were possible.

The CCI helps figure out what the typical price (TP) of an asset may be at a given time.

This is done by finding the mathematical mean of the high, the low, and the close prices and using this to determine the TP.

Calculating a simple moving average for the price movement is the second step in determining the indicator’s reading. The final step to coming up with the CCI reading is this equation:
 
CCI = (typical price – moving average) / (0.015 x mean deviation)
 
When the indicator was created, the 0.015 constant was used as a way of having between 70% and 80% of the readings fall between +100 and -100.

The idea is that if readings rise above the 100 level, or if they fall below the -100 level, it shows that we are seeing an unusual deviation from normalcy.

When we see these moves, the market is indicating overbought or oversold conditions - information you can use to underpin your strategy.

Applying the CCI on MetaTrader 4 and 5


To apply the indicator on a chart in MetaTrader, click on the ‘Insert’ tab, then the ‘Indicators’ tab, followed by the ‘Trend’ submenu, and finally on the Commodity Channel Index choice.

You can then can choose the standard settings and attach the indicator, or customise the settings as you wish.

One thing to bear in mind: choosing a too-short period (the default is 14) will make the indicator too sensitive to be useful.

Reading the CCI on a MetaTrader platform


As mentioned previously, there are two areas that suggest an overbought or oversold condition.

The idea is that when the market sends the signal line above the +100 level, the trader should start to look for signs of selling or rolling over by the market.

On the other hand, if the signal line drops below the -100 level, then the market looks likely to be oversold, and the trader should be looking for the signs of a reversal.

While the market is in an overbought or oversold condition, the trader will look for candlestick formations or perhaps another indicator to tell them when it is time to act.

 Take a look at the chart below.

The CCI indicator attached at the bottom of a chart

 You can see that the first set of red arrows was when the CCI spiked well above the +100 level.

You can see that the market went on to drop from there as the New Zealand dollar fell from extreme highs.

The next arrows suggest an oversold condition, and therefore - in theory - a buying opportunity. However, this signal failed.

Conversely, the next two signals, the first one a sell signal and the second a buy signal, both worked out.

The very last set (not marked by an arrow) is a sell signal that has yet to play out completely. In other words, out of the first four signals, three of them were profitable.

However, no indicator is perfect, so traders use candlestick formations or perhaps moving averages to help confirm opportunities.
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