I chose to write on CCI-3 thanks to a reader request which was the latest comment on the blog. So it is really a case of last request accepted.
The CCI stands for Commodity Channel Index. The term 'channel' in the name could be misleading, since the indicator does not actually create a channel, it plots a single line. Also, it is not exactly an 'Index' and it is suitable for all security types - stocks, futures, commodities, therefore it is not directly related to commodities. So much for the name.
The CCI is a momentum indicator. Momentum measures the rate of change in prices. If prices are furiously moving up, then momentum moves up with prices. If prices are moving up although at a slow pace, momentum will slow down, and, in most cases actually start falling. The fall reflects the slower increase in price.
Donald Lambert the developer of CCI suggested using a 20 period lookback to calculate the indicator. The CCI oscillates around a zero line, but it is not a bounded indicator. It is not restricted to values between 0 and 100. Lambart suggests using +100 as the resistance level and -100 as the support level.
The CCI can be used in many ways:
•CCI can be used to identify overbought and oversold levels. A security would be deemed oversold when the CCI dips below -100 and overbought when it exceeds +100. From oversold levels, a buy signal might be given when the CCI moves back above -100. From overbought levels, a sell signal might be given when the CCI moved back below +100.
•As with most oscillators, divergences can also be applied to increase the robustness of signals. A positive divergence below -100 would increase the robustness of a signal based on a move back above -100. A negative divergence above +100 would increase the robustness of a signal based on a move back below +100.
•Trend line breaks can be used to generate signals. Trend lines can be drawn connecting the peaks and troughs. From oversold levels, an advance above -100 and trend line breakout could be considered bullish. From overbought levels, a decline below +100 and a trend line break could be considered bearish.
•The CCI can also be used as a Trend Indicator. A move above +100 can be considered as the start of an uptrend. The uptrend remains intact so far the CCI remains above +100. A move below -100 can be considered as the start of a downtrend. The downtrend remains intact so far the CCI remains below -100.
AmitKBaid1008 wrote "Last two posts from you were much educating ones. I would like to know about using CCI(3) for identification of pullbacks"
When the default value of 20 as lookback is changed to 3, the indicator will quickly move from +100 to -100. Even a slight pause in prices will bring the indicator down to -100. The purpose of CCI-3 is to identify quick pullbacks where an uptrending stock dips / pauses for a few days and its CCI-3 falls to -100 or lower. A decline to -100 suggests that the short term dip is likely to be over. The reverse is true for downtrending stocks where a rally above +100 will tell the trader that a short rally is likely to be over and the original trend (down) will assert itself.
The CCI-3 should be used only where the trend of the stock is clear, only with strongly trending stocks.
Its use on intraday charts is limited, since there will be a lot of noise, causing whipsaws. Ideally, it should be use on the daily time frame.
Once the CCI-3 dips below -100 (in an uptrend), the question of trading tactics comes up. The dip in the CCI is an indication of an oversold condition, but prices may still go down before a reversal. A stop loss can be triggered at the worst possible location. This problem can be resolved by buying above the high of the latest bar, and, installing a stop below the low of the dip. Often, a dip in the CCI-3 is immediately followed by a big range day. Buying above the high could mean missing such moves, and, actually ending up at the top of a short term trend. That's a pity but the trader does not have to trade. If the CCI-3 is immediately followed by a big range day, then the trader can step aside. Sometimes, he may be lucky enough to spot such trades intra day , since he already has a short list of stocks where such moves could be expected.
Once inside a trade, look to exit on any Range Expansion (a big move in your favor) or when the CCI-3 goes above +100, or in a specific time , example: exit on the open of the third day, assuming the earlier two exits have not been trigggered.
Your feedback will be appreciated, since I have explained the concept as I understand it, maybe missing some critical elements of the strategy.