Commodity Channel Index: A Versatile Indicator

There is a plethora of tools that you can use to make your options trade better. Some tools help give you signals to make trade entries, some tell you about a trend’s strength and direction or some tell you about volatility. However, when trading options, you have to be aware of extreme occurrences. You need to get warned before such thing happens.

CCI does the same thing. It warns you about extreme conditions and tells you about new trends. Although originally developed for commodities, this indicator can also be used for indices and currencies. The CCI helps determine the cyclical trend of an asset’s price. It quantifies the links between an asset’s price, regular deviation and moving average of the price. Despite more than two decades old, CCI has witnessed popular adoption amongst seasoned traders.

The formula to calculate CCI is as follows:

CCI = (price – Simple Moving Average of price) / (0.015 * standard deviation of price)

where price is ‘Typical Price’, which is:

TP = (Daily High + Daily Low + Daily Close) / 3

The standard deviation of price is arrived at in 3 steps. The SMA gives your mean values, hence in the first step you need to subtract each day’s mean from its ‘Typical Price’ and take only absolute values. If you are calculating 20 day CCI, you need to do this subtraction starting from 20 days prior to the current date. In the second step sum up these values and lastly divide them by the number of observations, say 20. Because of the constant 0.015 most of the regular values of CCI remain between -100 and +100.

You will observe that the CCI measures the variation between an asset’s price and its average change. A higher positive CCI reading tells you that the asset is strengthening, whereas lower negative CCI reading tells you the opposite.

You can apply this indicator in your trades as a coincident indicator or as a leading indicator. Under the former type of application when CCI rushes above +100 it shows a very strong price action and it points towards a possible uptrend. When the CCI readings sink below -100, it reveals that the price action is weak and signals a probable downtrend. Through the prism of a leading indicator, CCI can help you detect overbought and oversold conditions as well as momentum shifts.

by James Franklen from Intellitraders.