Commodities traders often use strategies including mean reversion and other technical indicators to trade commodities. In order to do so, they need to measure the volatility and momentum trends in a commodity.
The Commodity Channel Index (CCI) helps investors identify changes in momentum by analyzing the current price level relative to an average price level over a given period of time – typically 20 days. From this information, investors can spot momentum trends and reversions in a trade.
In this article, we’ll break down the concepts used in the CCI and explain how they can be analyzed in context with a few examples.
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How the Commodity Channel Index is Calculated
To understand exactly what the CCI is telling investors, we first need to take a look at how the number is derived. The formula is as follows:
CCI = (Typical Price – 20-day SMA of the Typical Price) / (0.015 * Mean Deviation)
Typical price = (High price + Low Price + Closing Price) / 3
The CCI was designed to return a value between -100 and +100 in around 70% to 80% of cases. The variable that primarily contributes to this value is the length of the look-back period – a shorter period will be more volatile while a longer one will be be less volatile, thus returning more values between -100 and +100.
The CCI tells investors something about a commodity’s current price compared to its average value. A positive number translates to an asset trading above its average price, indicating a bullish momentum, while a negative one indicates that it’s trading below its average price and could be a show of weakness in the asset.
It can also be interpreted as a price movement indicator. Three major trends can be identified through the CCI – emergent trends, overbought or oversold signals, and bullish or bearish divergences. The resulting number can tell an investor a lot about where the price of the commodity might be headed next, helping them better identify opportunities.
To know more about the basics of CCI, click here.
Trends Identified Through the CCI
New Trend Emerging
Normally, the CCI number will be between -100 and +100, but when the actual number is outside of this range, it tells investors something about the way the asset is trading. If the figure is above +100, it can be indicative of a bullish new trend in an asset, while a number below -100 generally means that a bearish trend is developing.
Let’s take a look at how Tesla (TSLA) has been trading through a CCI filter and 20-day SMA. The first thing you may notice is where the CCI line (indicated on the bottom graph) crosses above and below the -100 and +100 line. Comparing it to the price movement in the stock reveals a pattern – the stock tends to climb when the CCI line crosses above +100 and dives when it crosses below -100.
Overbought and Oversold
The CCI can also be used to spot overbought or oversold assets, although the definition of these signals is subjective. Technically speaking, even if an overbought or oversold signal is seen, there’s nothing that says that the momentum in the asset should rebound. An asset can still move higher or lower after the signal is spotted, so investors need to be careful when relying on the CCI for these types of indicators.
Like an emerging trend line, an overbought or oversold signal is identified by an extreme variance – in this case below -200 or above +200. As one might expect, a number below -200 indicates an asset that may be oversold, while a reading of more than +200 could indicate an asset that’s overbought.
Taking a closer look at Silicon Motion Technology’s (SIMO) stock chart, we can see where the CCI jumps above and below the +200 mark several times in the past five months. As with the chart before, we can compare these events to movements in the stock price and see the impact it had. Very soon after crossing the +200 line, the stock price either climbed or dropped, depending on whether it was a negative or positive value.
Bullish and Bearish Divergence
Using what we’ve learned from the CCI line so far, we can spot one last indicator – bullish and bearish divergences. By mapping out different higher or lower endpoints from two significant CCI movements, investors can spot divergences where the asset could change direction.
A chart for Agilent Technologies (A) shows us three different divergent indicators. Notice the two CCI peaks below -100 in May where the second peak was less than the first. Now trace that to the stock price and notice where it jumped higher in the beginning of June. The opposite effect can also be seen in August and late September.
The Bottom Line
Commodities traders rely on technical indicators more so than equity traders to create profitable positions. The CCI momentum oscillator is a useful tool for spotting three different trends that can help investors predict future price movements. The key is to remember that values that exceed the normal range of -100 to +100 can be significant and should garner investors’ attention when they see it.
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