How To Trade The Overbought And Oversold Commodity Channel Index Like a Pro?

What is the commodity channel index indicator?

The commodity channel index is a momentum indicator developed by Donald Lambert. It reveals the moment when a new trend begins and highlights overbought and oversold conditions. It measures the current price relative to a moving average and oscillates between +100 and -100. Theoretically, the market is overbought when the CCI is above +100 and it is oversold when the CCI is below the -100 level. Please note that theory and reality are not always the same. Quite often, the commodity channel will duplicate or will accurately reflect the price’s movement. Nevertheless, it is common to notice divergence between the CCI indicator and the price. This divergence comes in the form of fake divergences and valid divergences. All valid signals are validated by the price. The CCI is also a leading indicator, but one must know how to use a leading indicator in order to avoid sour disappointments.

After careful observation of this magnificent indicator, we have noticed, shocking resemblances between the commodity channel index and the humble “Bollinger bands”. Bollinger bands are trading tools created by John Bollinger in 1980 to highlight the dynamism of volatility. The bands include one middle band as well as two outer bands that deviate from the middle band. Traders use standard deviation plus and minus two when plotting the “Bollinger bands”. Similarly, the CCI indicator consists of one middle band (zero level) and two outer bands. The upper band is the +100 level and the lower band is the -100 level. It is obvious that the CCI indicator is seeking to play the role of the price within a Bollinger. When one substitutes the price for the CCI indicator and moves the “Bollinger bands” to the outer +100 and -100 levels, there is no doubts that the Bollinger bands and the CCI indicator become perfect substitutes for each other.

After these clarifications, we can efficiently use the commodity channel index (CCI) indicator. Please note that when the CCI period 14 is above +100, the price is usually at the upper band of the Bollinger 14, volatility two; when the CCI period 14 is below the -100 level, the price will usually be at the lower band of Bollinger 14, volatility two. When the CCI period 14 is at the middle line, the price, in most cases, is at the middle line of the “Bollinger bands” 14, volatility two. When we compare the CCI period 50 to the Bollinger (50,2) and the CCI period 20 to the Bollinger (20,2), we find that there are many overt similarities between the Bollinger bands and the commodity channel index indicator. To compare the Bollinger bands to the CCI indicator, one must use the exponential moving average settings for the Bollinger bands. These settings are crucial. Both the CCI indicator and the “Bollinger bands” must have the same period before a valid comparison can take place. Divergences do take place. For instance, when the price is still at the upper band of the Bollinger (20,2) but the corresponding CCI period 20 has pulled back near the middle line (zero), there is a high probability but not a certainty that the price may also pull back to the EMA20. If the price is still at the lower band of the Bollinger (20,2) but the CCI 20 rallies up to the middle line (zero), the price, under normal conditions, will rally up to the EMA20. One can note the same observation when using the commodity channel index (CCI) period 50 and the “Bollinger bands” (50,2). Please note that the “TSTW24” uses the Bollinger (50,2). It is important to remember that the price is the number one indicator, because we are trading the price, not the commodity channel index itself. All valid signals received or derived from the CCI indicator are validated by the price. A signal is one thing, but the entry point is the key.

Trading the overbought and oversold CCI like a pro.

No indicators, either leading or lagging, will ever completely replace the price. Never ever forget that. We are trading the price, not the indicators. One should not seek to complicate trading but to simplify it. When the commodity channel index (CCI) indicator is overbought above the +100 level, many traders will quickly place orders to sell without further verification. These are traders who trade the indicator, not the price, and they will go from one trading system to another trading system and blame their lack of success on everything except themselves. Trading the indicators instead of the price is one major cause of consistent losing trades. The CCI is often overbought right from the beginning of a new up trend or during the third “Elliott wave”. While the educated traders are busy placing orders to buy, ordinary traders are selling and losing abundantly because they fail to recognize that a resistance is broken and validated as a support level, while the CCI is still overbought. Either that, or they did not recognize that a trend line has been broken and, retested and that the price has turned around. When the CCI indicator is overbought, it is alerting traders that, bullish momentum has increased and that the price is in a resistance zone (overbought), period. It does not mean that you should sell or waste your money. Traders must highlight the indicated resistance zone and follow the price. If the resistance is broken and the price finds support above the resistance zone, traders should buy even though the CCI is still overbought. Below are some simple trading rules that, one can follow.

Anytime a signal is given, acknowledge the signal.

Do not enter the trade too quickly; instead, keep your eyes wide open.

Ask the two most important questions: “Is it time” and “Is it the place to enter the trade?”

Wait for validation ( the price must always confirm the signal).

Consider the risk-reward ratio, check the economic news, and enter the trade only and only after validation.

Always use stop-loss.

One should not seek to sell immediately when the CCI is overbought but to wait for either the trend line or a support level to be broken, retested and validated as a resistance level. The price must turn around and bearish momentum must increase. On the other hand, when the CCI indicator is oversold below -100, we will not buy straight away. We will wait for the trend line to be broken to the upside or a resistance level to be broken and validated as a support level. The price must turn around and bullish momentum must increase. If the commodity channel index (CCI) indicator is oversold but a support level is broken and validated as a resistance level, we must sell even though the CCI is oversold. As you can see, paying attention to the price, will aid traders in making excellent trading decisions. The commodity channel index indicator can be oversold right from the beginning of a new down trend, leading unaware traders to buy. Stubborn, aggressive traders usually lose serious amounts of money during the third “Elliott wave” in a down trend, because the CCI usually remains oversold during this bearish wave.

Using the commodity channel index indicator with the “Elliott wave” theory will allow traders to make better trading decisions. The market is considered overbought at the end of the fifth “Elliott wave” in an up trend, and the CCI is also overbought at the end of the fifth wave. On the other hand, the market is considered oversold at the end of the fifth “Elliott wave” in a down trend. At this point in time, the CCI is oversold. Traders will wait for confirmation in these “hot spot trading zones” to take part in the abc corrective waves. Fake overbought and oversold signals are given during the third “Elliott wave.” However, valid overbought and oversold signals are often given at the end of the fifth “Elliott wave.” Please wait for validation before entering the trade. When the CCI is oversold, bullish momentum has decreased. The oversold CCI highlight a support zone. A support zone can break and become a resistance zone. In this case, we will sell even though the CCI is still oversold. When you sell, pay attention to the nearest support level; when you buy, pay attention to the nearest resistance level. Do not buy right into a resistance level. Instead, wait for the price to cross above the resistance level, and vice versa. The overbought or oversold CCI can indicate the beginning of a new trend. Do not trade against the new trend.

On the 4th of March 2010, IBM’s daily chart showed that, the commodity channel index period 14 was oversold (below -100), highlighting a support zone around 127.98. As ordinary traders were busy placing bullish bets, the price broke, retested and validated the support level as a new resistance zone. The CCI was still oversold when the bearish momentum was increasing. Naturally, the price went from 127.98 down to the 116.00 level from the 4th of March 2010 to the 6th of March 2010, a huge drop but a serious gain for educated traders. The drop was fast. Many traders who were buying the oversold CCI did lose, and those who failed to apply the five per cent money management rule also lost. Therefore, traders need to master the oversold CCI. The inverse scenario took place on the 22nd of December 2010. On that day, IBM was at 145.95, but the CCI period 14 was above +100 (overbought). The CCI period 14 was highlighting the resistance zone between 145.50 and 147.00. As always, as soon the CCI period 14 was overbought, the smart traders highlighted the identified resistance zone and waited for validation. I use the “TSTW SYS 08” in this 22nd of December case, because anything is possible here. The price can go up, down or horizontal. Do not try to guess it, and do not be too confident. On the contrary, do be calm and, wait for your turn (so to speak). While ordinary traders continued to sell IBM without further verification, the price broke and retested the resistance zone from the 6th of January 2011 to the 11th of January 2011. The price turned around on the 12th of January 2011 after retesting the resistance zone. Once again, uneducated traders lost when the price continued the movement to the upside. From the 12th of January 2011 until the 25th of January 2011, IBM was rising and the bullish momentum was rising, even though the commodity channel index indicator period 14 was in the overbought zone. Without doubt, price can rise when the CCI is overbought, and it can fall when the indicator is oversold. On the 25th of January 2011, IBM reached the 161.44 price level, which was a serious move. Many other examples are relevant, but their pattern remains the same. This strategy remains valid whether, you are trading currencies, stocks, options, futures, or any other financial instruments.

The price is the most important and number one indicator. It must confirm both the overbought and the oversold commodity channel index signals. The overbought or oversold CCI signals are neither signals to sell systematically nor signals to buy without further verification. The ability to “filter out fake signals” and to understand both the language of the price and the language of the overbought and oversold commodity channel index will allow traders to enjoy their trades rather than endure their trades. We hope that, you find this article useful and that you will put it into practice in order, to avoid losing money. Do not guess the price; instead, follow it. Trade like pro, or learn to “trade like a pro.”



Source by George Beaulieu


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