- 1997: Volume 6, No. 2 Chartist Corner: Commodity Channel Index

Price momentum for any market can be a subjective measure. When an indicator has no predefined boundaries, such as RSI's 0 -100, one must look back over the indicator's history to see similar levels (and even these levels can change over time). Seasonal influences, trend changes, and absolute price levels all lead to ambiguity in reading market momentum.

The Commodity Channel Index (CCI) was created in 1980 by Donald Lambert with the intent to normalize momentum readings and account for cyclical changes in the markets. He did this by taking the current price, subtracting a moving average and then dividing it by a measure of its trading range over "n" periods. A constant was then added to the divisor so that 70 to 80 percent of all CCI readings would fall in the "normal" zone of -100 to +100. Anything above +100 was considered to be overbought and anything below -100 was considered to be oversold. (The formula can be found in Figure 1.)

Figure 1

The formula to compute CCI is as follows:
CCI = Typical Price - Moving Average 0.015 * Mean Deviation
Where: Typical Price = Moving Average = Mean Deviation =	Average of the High, Low and Close Average of the Typical Price for "n" periods Average Spread of the above for "n" periods

Lambert believed that the value of "n" should be 1/3 of the cycle length for the market but realized that this was subject to whipsaws (bad signals). To reduce the problem he settled for an "n" value of 20 data periods as being the right compromise between cyclic behavior and indicator sensitivity.

Using the CCI

Like all momentum oscillators, the basic theory tells us to sell when the market is overbought and buy when it is oversold. However, these extreme readings can be misleading in some types of markets. The CCI works best in flat markets and markets that exhibit cyclical behavior. In Figure 2, the CRB Index was in a trading range for several months. Whenever CCI values were in the extreme regions (below -100 and above +100) and then crossed back into the central region, a trading signal was given. For example, in early September 1994, the index was above +100. When it crossed back below that level, a sell signal was given. This signal was generated four days before the big move down.

Figure 2

For trending markets that exhibit cyclical behavior, the divergence between the CCI and price can be used. In Figure 3, Knight-Ridder stock made higher highs in January while the CCI did not. CCI broke its trend line and fell below +100 several days before the stock price tumbled. Another occurrence of this divergence happened in July. Prices made higher highs while the CCI made lower highs. Once again, the combination of CCI trend break and cross below +100 happened days before the stock broke its own trend line.

Figure 3

Some analysts apply a three-day period moving average to the CCI and trade when the CCI crosses that average. Most use it without the average to identify overbought and oversold conditions within the natural peaks and valleys of cyclical markets.

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.