Introducing the Commodity Channel Index

The Commodity Channel Index (CCI) was introduced in 1980 by Donald Lambert as a way to chart cyclical turns in commodity prices. I don’t trade commodities, so you are probably wondering why I would take an indicator and plug it into trading something like the financial indexes. I wish I could claim to be the first one to do so, but that is far from the case. Scores of day traders use the CCI to trade a variety of trading systems with excellent success, and I simply plugged the CCI into my system. The fact of the matter is one of functionality, regardless of what the Commodity Channel was designed to do, it works well as a daytrading tool. Functionality over form, I suppose.

So what, exactly, is the CCI in relation to day trading?

The formula to calculate the CCI is as follows:

CCI = ( Typical Price - SMATP ) / ( .015 X Mean Deviation )

Thankfully, you will not have to calculate the CCI by hand, unless you want to bone up on your mathematic skills, because most day trading charting program have the indicator included in their trading package. Notice that the constant being multiplied (.015) to the Mean Deviation is a fixed number. That is no accident, as Lambert found using .015 kept the majority of price action, specifically, 70-80%, between the +100 and -100 lines. I have actually written several programs where the constant is different than .015 and had some great success. However, the .015 will work just fine for our purposes.

Lets talk some about “overbought” and “oversold” levels in the security you are trading. Conventional knowledge would indicate selling out of an equity when it reaches an overbought level. I tend to disagree with that analysis, as people (especially traders) are not the logical calculating cabal you might expect. You see, I like momentum in trading, and when a security reaches an overbought level, daytraders who missed the trade tend to pile into to security hoping to catch whatever upward movement they may have missed. Of course, this only adds to the upward movement, and the security continues along it’s merry way, further up. Time and time again I have watched this phenomena.

Having said that, I define overbought and oversold as the +100 and -100 lines on the CCI. Further, I define market noise as anything between the +100 and -100 lines. Those definitions work pretty well for daytrading. I realize that using these assumptions challenges some conventional thinking about the market. But this model works well for my purposes as a scalper. (a day trader who is looking to take small chunks out of a short term trend)

I am trying to avoid trading during periods of market noise, when the market is going through the tedious backing and filling process, and only trade when the market is breaking out or breaking down. The CCI and it’s magical +100 and -100 lines gives me an excellent snapshot of when to trade. By that, I am referring to overbought and oversold conditions.

In the formula above, the other constant is 20, and this indicates the number of time periods the program will use in the averaging process. So the formula, to be clear, is using a 20 period average. I don’t use 20 period averages when trading. I generally set the time period to 16, sometimes as low as 10. I have found that a quicker time period makes me more nimble in entering and exiting trades. You may want to start at 20 time periods, and see if that number is a good fit for your trading style.

I don’t use the CCI as a stand alone indicator. For that matter, I don’t use any indicator as a stand alone. No, I find it important to use several other indicators to confirm buy and sell signals. As a trader, I cannot put my trust in any single indicator.

To summarize, the CCI is an indicator that was developed to chart cyclical changes in the commodities market, and I fiddled with it’s settings and found it effective in trading the financial index markets. The Commodity Channel Index has several constants in the formula, and I have chosen to alter those constants to fit my needs. Finally, I have a set view on the market which is defined by the +100 and -100 lines on the index, and use the index to set my view as to defining the following terms:

1. Market noise 2. Overbought condition 3. Oversold condition

Take some time and play with this indicator. I think you will find it’s versatile and nimble in the markets and worthy of your attention. Just don’t put too much stock in a single indicator, seek out the relationship of the indicator and price action and the synergistic relationship it shares with other confirming indicators.

I am a long time retail and institutional trader who now only trades part time, usually in the morning. I enjoy writing informational articles about my style of trading so others may benefit.

I endorse a state of the art trading program for beginners at http://www.emini-mavensite.com/tradingconceptsmlm.html -Trading Concepts, Inc. It's an awesome product that will have you well on your way to success. Plus, it has a money back guarantee...you have nothing to lose and thousands to gain.

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