Interpretation
There are two basic methods of interpreting the CCI: looking for divergences and as an overbought/oversold indicator.
A divergence occurs when the security’s prices are making new highs while the CCI is failing to surpass its previous highs. This classic divergence is usually followed by a correction in the security’s price.
The CCI typically oscillates between 100. To use the CCI as an overbought/oversold indicator, readings above +100 imply an overbought condition (and a pending price correction) while readings below -100 imply an oversold condition (and a pending rally).
Example
The following chart shows the British Pound and its 14-day CCI. A bullish divergence occurred at point “A” (prices were declining as the CCI was advancing). Prices subsequently rallied. A bearish divergence occurred at point “B” (prices were advancing while the CCI was declining). Prices corrected. Note too, that each of these divergences occurred at extreme levels (i.e., above +100 or below -100) making them even more significant.
Calculation
A complete explanation of the CCI calculation is beyond the scope of this book. The following are basic steps involved in the calculation:
1.Add each period’s high, low, and close and divide this sum by 3. This is the typical price.
2.Calculate an n-period simple moving average of the typical prices computed in Step 1.
3. For each of the prior n-periods, subtract today’s Step 2 value from Step 1′s valuen days ago. For example, if you were calculating a 5-day CCI, you would perform five subtractions using today’s Step 2 value.
4.Calculate an n-period simple moving average of the absolute values of each of the results in Step 3.
5.Multiply the value in Step 4 by 0.015.
6.Subtract the value from Step 2 from the value in Step 1.
7.Divide the value in Step 6 by the value in Step 5.
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