Trading with Clouds – Fast and Effective
This article introduces the Ichimoku Kinko Hyo, an award winning Japanese technical indicator which can be used to trade currencies, commodities, futures, and stocks.
Ichimoku means: one glance, Kinko means: equilibrium (or balance), and Hyo means: chart, which reads “one glance equilibrium chart”, describing how traders can very quickly discern price action of an asset, and form trading decisions effectively.
While this indicator can be implemented alongside other indicators such as trendlines and Fibonacci retracements, it is a powerful trading system on its own as it combines elements of time, sentiment, volatility, support and resistance.
How it All Began
Figure 1. Japanese Ichimoku Kinko Hyo materials
Ichimoku Kinko Hyo was created by a Japanese newspaper man named Goichi Hosoda. After twenty years of testing and refining, the system was released to the public in 1968. Step into any Japanese trading room and you will see the indicator displayed across most of the traders’ screens.
Only recently did the Western world adopt this trading system due to the lack of traders willing to translate the methodology into the English language, thus keeping this trading secret well kept among the Japanese community. But this is fast changing, with the adoption of this trading indicator growing exponentially in recent years, with applications across asset classes (even options trading).
Five Lines in One System
At first glance, the indicator looks messy like a child’s painting. With a little patience and practice, this “mess” ironically makes chart reading a breeze. Here’s a snapshot:
Figure 2. Typical Ichimoku Kinko Hyo chart
As you can see labelled in green, Ichimoku Kinko Hyo is composed of five separate lines which fit perfectly together to give you a picture of the asset’s price action. We view trading as both art and science; while there are rules to abide by, the Ichimoku Kinko Hyo picture creates an art piece around prices. In the segments to follow, we will explain how we can appreciate this art of trading.
The most distinctive feature of the Ichimoku Kinko Hyo is the red and blue cloud you see stretching across (and ahead of) price. Yes this is one of the rare indicators which forecasts price action ahead, contrary to what most believe technical analysis to be backward looking. Also known as the Kumo, the cloud is created by the two lines “Senkou Span A” and “Senkou Span B”. It is primarily an ever-changing support and resistance zone, serving as resistance above price and a resistance below price. At one glance, you can see whether price is currently bullish (above the cloud), bearish (below the cloud) or consolidating (inside the cloud).
Figure 3. Price position relative to Kumo
Trading Strategy: Kumo Break
Traders commonly look to enter long positions when price breaks resistance levels and conversely, short positions when price breaks support. A similar methodology can be applied by going long when prices break above the cloud, and going short when prices break below the cloud. Why the cloud is special:
- As most indicators such as Fibonacci/ Pivots/ Trendlines define support and resistance levels as lines in the sand, traders often find themselves getting stopped out of their positions because their lines were drawn a little too high or low. With the cloud, support and resistance is a range, which is multi-dimensional and more meaningful for taking trading positions.
Figure 4. Kumo acts as support/ resistance
- The cloud varies in height as price action changes. This height represents volatility in the market as wider price movements form a thicker cloud. A thicker cloud also means the support/resistance is stronger, and likely to keep price trending one direction. A thinner cloud warrants caution as it is susceptible to price breaking through it in the opposite direction.
- You will also notice that the clouds twist, highlighted by a change in colour between red and blue in the colored charts, as the Senkou Span A crosses the Senkou Span B. Generally, future price action is bullish when Span A is above Span B and bearish when Span A is below Span B. This “Kumo Twist” can thus serve as a confirmation for the Kumo Breakout strategy.
Figure 5. Bullish and Bearish Kumo Clouds
- We will go into the mathematics of Senkou Span A and Senkou Span B in later segments. For now, understand that current price is forming the cloud 26 periods ahead. Or put another way, the cloud at present was created by price action 26 periods ago. The cloud therefore allows us to look into the future support/resistance.
Figure 6: Cloud Formation 26 Periods Forward
The “Moving Averages”
Moving Average is arguably the most commonly watched indicator in the stock, currency and commodity markets. Price is expected to go bullish (bearish) when the faster moving average crosses above (below) the slower moving average. Calculation of moving averages is done by taking the mean of the past closing prices. A similar strategy is employed within the Ichimoku Kinko Hyo trading system with two lines; Tenkan Sen and Kijun Sen. We will now begin with the mathematics behind the Ichimoku Kinko Hyo components, starting with these 2 lines:
Tenkan Sen (“turning/conversion line”) = (HIGHEST HIGH + LOWEST LOW)/2 for the past 9 periods
Kijun Sen (“standard/base line”) = (HIGHEST HIGH + LOWEST LOW)/2 for the past 26 periods
These two lines signal trades like the standard moving average crossovers, but their calculation is quite different. Instead of utilising the mean of closing prices, they take the average of the highest high and lowest low of prices. This will allow us to determine the price equilibrium/ midpoint, which is also the 50% retracement if you draw a Fibonacci line between the highest high to the lowest low. Looking at price action relative to its equilibrium is the essence of the Ichimoku Kinko Hyo.
Figure 7: Price Action Relative to Price Equilibrium (Blue Line)
Unlike the Simple Moving Average (SMA), Tenkan Sen and Kijun Sen lines often have flat portions which represent equilibrium and quite naturally, we see prices retracing back to their equilibrium. Savvy Ichimoku Kinko Hyo practitioners often wait for retracements before taking trades. As the Kijun Sen measures price action over a longer historical period, it is a more reliable indicator of sentiment and equilibrium, reflected by the longer flat lines/equilibrium compared to the Tenkan Sen.
This qualifies the Kijun Sen as a more significant level of support and resistance and traders tend to place their stop loss/exit orders near to these lines. Tenkan-Sen is more sensitive to minor price movements and represents momentum.
Figure 8: Comparing Tenkan Sen and 9 Period SMA
Except for one instance in the chart above, prices stayed above the Tenkan Sen in the areas highlighted in yellow, while prices dipped below the SMA numerous times. We thus see how Tenkan/Kijun Sen can be more accurate than the SMA. The angle of the Tenkan Sen also shows us the momentum of price action, with stronger momentum depicted by a steeper angle.
Trading Strategy: Tenkan Sen/ Kijun Sen Crossover
Traders can look to go long (short) when the Tenkan Sen crosses above (below) the Kijun Sen. Unlike traditional SMA strategies, the strength of the Tenkan Sen/ Kijun Sen Cross can be ascertained based on its position relative to the cloud as follows:
- A strong tenkan sen/kijun sen cross Buy (Sell) signal takes place when a bullish cross happens above (below) the kumo.
- A neutral tenkan sen/kijun sen cross Buy/ Sell signal takes place when a bullish cross happens within the kumo.
- A weak tenkan sen/kijun sen cross Buy (Sell) signal takes place when a bullish cross happens below (above) the kumo.
Traders can exercise risk allocation and position sizing based on the strength of the crossover. The more conservative Ichimoku Kinko Hyo practitioners ignore weak crosses altogether.
Figure 9: Tenkan Sen/ Kijun Sen Cross Strategy
Identify Support/Resistance Lines
The Tenkan Sen, Kijun Sen, Senkou Span A and Senkou Span B all serve as support/resistance lines. Let’s take a look at this example:
Figure 10: Four Resistance Lines
From the price lows of a bearish environment, we see the price bars systematically breaking four levels of resistance, starting from the Tenkan Sen, then the Kijun Sen, followed by the Kumo bottom, and finally piercing through the Kumo top. It is visible how these four lines show increasing levels of resistance in the order stated. The converse applies when price action is bullish and the four lines serve as support levels.
Now that we have learnt how to calculate the Tenkan Sen and Kijun Sen, we can move on to the cloud mathematics. As mentioned, the Kumo is constructed by the Senkou Span A and Senkou Span B:
Senkou Span A (“leading Span 1”) = (Tenkan Sen + Kijun Sen)/2 time-shifted forward 26 periods (into the future)
Senkou Span B (“leading Span 2”) = (Highest High + Lowest Low)/2 for the past 52 periods time-shifted forward 26 periods (into the future)
This will create the Kumo 26 periods ahead of current price, therefore giving us direction with regards to future support and resistance.
History of 9, 26, 52
At this point, many of you are probably wondering how the number of periods 9, 26 and 52 came about in the various formula. As this indicator was created before WWII, Japanese financial markets were open for trading on Saturdays, meaning that the trading week was six days long.
9: represents a week and a half of trading
26: represents the number of trading days in a typical month (30 minus four Sundays)
52: represents two months of trading days
Japanese markets today trade only 5 days per week and 22 days in a typical month, so some practitioners of Ichimoku Kinko Hyo suggest revising the parameters to 7 or 8, 22 and 44. Others choose to follow the Fibonacci numbers of 8, 21 and 55. You can try the various parameters but every technical trader knows that indicators have a certain degree of self fulfilling traits, in the sense that if many people are (or have been all this while) looking at a certain indicator set with certain parameters, that indicator setting will work best. And this is the same for the traditional 9, 26 and 52 parameters for Ichimoku Kinko Hyo, based on our experience.
Last But Not Least
We have so far introduced four components of the Ichimoku Kinko Hyo trading system. The last, and some say the most important, is the Chikou Span, also known as the lagging Span. Its calculation is simple:
Chikou Span (“lagging line”) = Current closing price time-shifted backwards 26 periods (into the past)
Figure 11: Picture of Bullish Chikou Span
Here you can see that the Chikou Span is simply the current period’s price shifted back 26 periods. When Chikou Span (purple line) is above price (26 periods ago), price action is bullish.
Some traders choose to remove the Chikou Span from their charts because they are able to visualise the Chikou Span without the need for the purple line. The Chikou Span is typically used as a final confirmation before entering a trade. In the chart example above, you may have a trade entry signal on a bullish kumo break; at this point many Ichimoku Kinko Hyo traders will use the bullish Chikou Span as a confirmation of a long position.
Figure 12: Picture of Bearish Chikou Span
In the chart above we see Chikou Span below price, a sign of bearish sentiment. In fact, price is in a strong bearish environment as we see a bearish Kumo ahead (Senkou Span A below Senkou Span B), as well as prices below the Kumo.
However the bearish trend may soon reverse, as we see Chikou Span threatening to “poke” through the candlesticks, as well as a potential weak bullish Tenkan/ Kijun cross up ahead. This is one way in which the Ichimoku system can identify trend reversals, and also an example of how the five components can work together to give you a picture of price action.
A Dynamic Trend-Following System
Figure 13: Overview Chart
The Ichimoku Kinko Hyo is largely a trend-following indicator, with the Tenkan/ Kijun cross as the key trigger for many traders. That being said, the multiple data points of the Ichimoku are to be used together to give the trader a well rounded picture of price action. Other indicators commonly used together with the system are Fibonacci retracements, pivot points, trend lines as well as the 20-day SMA, which is watched over by many institutional traders.
It is also useful to consider multiple timeframes when trading. For example if you trade the daily charts, you may want to visit the weekly and monthly charts to see where you are within the bigger trends. Alignment of shorter and longer period timeframes provides stronger conviction for your trading decisions.