As a Chartered Market Technician, I get a lot of questions about technical indicators and how they work. In a recent XLT class, I was asked about the Commodity Channel Index (CCI) indicator as some of the students noticed I had it on my charts. The first thing I want to mention about technical indicators is that they are all lagging and are not to be used as decision making tools. In other words, when they give their buy and sell signals, it will always be at least one candle after the optimal entry point on price.
So how can we use these indicators? They can be useful as a decision support tool. Identifying divergence on an indicator or that you are in an overbought or oversold situation can help you identify high probability opportunities in the markets when price is at supply or demand.
I mentioned the terms overbought and oversold. I should explain what these mean. The CCI falls into the family of indicators known as oscillators. Oscillators typically have a level that marks overbought and oversold. In the case of the CCI, price of the security is overbought when the indicator reads over +100. This means that price has risen so much so fast that it has deviated from the average price much more than normal. There is a high probability that this movement is unsustainable and that it will snap back to the average soon.
The CCI oscillates above and below zero. When the CCI reads below -100, then price is said to be oversold. It has sold off to the point that it has dropped well below the normal deviation from the average. Price is currently unsustainable and is highly likely to snap back to the average soon. In all, the CCI measures how far price is moving away from an average price. We become overbought or oversold then price exceeds the normal movement (the standard deviation) away from that average.
The traditional buy or sell signal would be when price crosses the +100 or -100. As you can see from the picture however, this will always be either late or false!
So how do I use this indicator? I use it in two ways. First, I feel I have a higher probability for trading success if I buy fresh demand levels where the CCI is also oversold. I buy when price is in the demand zone and do not wait for the indicator to signal buy. I would also feel more confident selling a supply zone if the CCI is showing oversold. Once again I cannot wait for the traditional sell signal as it would arrive very late.
Probably the best signal I could receive from the CCI is when it is showing divergence from price. In a strong uptrend where price is making higher highs and higher lows, the CCI should as well. If price is reaching a supply zone but the CCI is making the same or lower highs than it did on a previous price peak, then it is diverging and that is a strong selling signal to me.
When I am looking to buy after a drop in price into a demand zone, I look for divergence in the CCI where it fails to make lower lows while price does.
So now you see why I have this CCI on my chart. I use it to help confirm entries and exits but never as the decision maker itself. I will always defer to price and trade at supply and demand zones. That is how you can succeed in trading.