Hackernoon logoIchimoku Cloud Explained by@leah-mathieson

Ichimoku Cloud Explained

Leah Mathieson Hacker Noon profile picture

@leah-mathiesonLeah Mathieson

Writing about law, Wall Street, VC & startups.

Ichimoku Cloud is a versatile technical analysis indicator rapidly rising in popularity among traders. Also known as Ichimoku Kinko Hyo which translates to ‘one look equilibrium chart’ - this is exactly what Ichimoku strives to be. An ‘all-in-one’ style indicator that incorporates multiple elements from different technical analysis tools. At just a glance traders are able to ascertain future support and resistance, momentum and trend direction.

While the abundance of lines and shaded areas can leave traders new to Ichimoku Cloud confused and even a little intimidated. Once you single out and understand each separate element, mastering Ichimoku Cloud is easier than it looks. We take you through each component of Ichimoku Cloud and the strategies you can use to improve your trading. 

What is Ichimoku Cloud?

Ichimoku Cloud essentially combines three indicators into a single chart so traders have multiple tests on price action. It can be used to analyse any tradeable asset, from stocks, options, futures etc. A key component of the indicator is the ‘cloud’ that acts as support and resistance. There are also five lines that represent different time intervals. These elements allow traders to decipher the strength of trend direction and gauge momentum which in turn can signal trading opportunities and optimal entry/exit points. 

There’s also an interesting origin story. Unlike most technical indicators that are formulated by statisticians and mathematicians, Ichimoku Cloud was developed by a Tokyo newspaperman Goichi Hosoda. By analysing the centuries-old Japanese rice markets, Hosoda came to the conclusion that markets are ‘human’ - they are social creatures in that they are both the product of and have an influence on human behaviour. Like people, markets can swing wildly but it is unusual to stay at extremes, there is always a return to equilibrium. After decades of endless computations and revisions, Hosoda and his team concluded that what is now known as Ichimoku Cloud, was the best chart representation of market reality and publicly shared the technique in 1968. The indicator is now heavily used by many Japanese trading rooms and rapidly growing in popularity worldwide. 

How does Ichimoku Cloud work?

If you’ve never looked at an Ichimoku Cloud chart before, you’d be forgiven for thinking ‘what a mess’. The abundance of squiggly lines can create a cluttered chart that makes many traders dislike. However, for those that subsist, understanding Ichimoku Cloud is simpler than it looks. But to fully comprehend Ichimoku Cloud, we need to break it down into its individual components and build it back up. 

The Components of Ichimoku Cloud

Tenkan Sen

The Conversion Line -  The short-term line that is the most responsive to price action. Represents the average of the high and low divided by two for the previous nine time periods. 

Kijun Sen

The Base Line - The long-term line that is less responsive to price action. Represents the average of the high and low divided by two for the previous 26 time periods. 

While the Tenkan Sen and Kijun Sen lines may look eerily similar to your traditional moving averages, there is one big distinction. They use the highest high and the lowest low over the time period instead of the closing price which is used in most moving average calculations. By taking the average of the price extremes and dividing by two, Tenkan Sen and Kijun Sen result in a line that more closely resembles support and resistance. While the difference in calculation may be subtle, the result is widely different even if the same number of periods are used.

Chikou Span

Lagging Span - Represents the closing price for the previous 26 time periods. Traders can easily gauge market sentiment and the intensity of trend direction by comparing current price movements with that of the previous movements.

Senkou A

Leading Span A - The future indicator for 26 time periods. It is calculated by taking the middle of Tenkan Sen and Kinjun Sen for the previous 26 time periods and plotting the values 26 time periods ahead of current price action. 

Senkou B

Leading Span B - The second future or leading indicator. It is calculated by taking the average of the highest high and lowest low of the previous 52 time periods and plotting the values 26 time periods ahead of current price action.  

Kumo

The Ichimoku Cloud - Is the shaded area between the Senkou A and Senkou B lines. It represents current and historical price action and it’s colour will change depending on the movements of the Senkou A and Senkou B lines. When Senkou A crosses above Senkou B, this signals an upward trend and the Kumo will be colored green (there may be a slight variation in color depending on your trading platform). Where Senkou A falls below Senkou B, this signals a downward trend and Kumo will typically be colored red. 

What is the best time frame for Ichimoku?

Ichimoku Cloud can be used in any market and in any timeframe. What is the best timeframe largely depends on your trading style. Scalpers and day traders may benefit from using shorter time periods from anywhere form one min charts to six hour charts. Although it doesn't hurt to zoom out to larger time frames to understand the bigger market picture. Longer term swing traders or investors are better suited to looking at daily or weekly charts. As with all trading strategies, your trades will still need to be managed, so pick a time frame that you can reasonably monitor and follow. 

How can you use Ichimoku cloud for day trading?

Trend Direction

A simple way to see trend is to look at the colour of the cloud. When the cloud is shaded green, there is a positive trend. When the cloud is shaded red, there is a negative trend. You can also factor in the size of the cloud to determine the strength of the trend. Where the cloud between Senkou A and Senkou B is small, this signifies that the trend is weak. A large cloud can be interpreted as a strong trend.

Another way to use the cloud is to look at current price action. Where current price is above the cloud, this further supports the strength of the bullish trend. Below the cloud, a bearish trend. And when the current price is located within the cloud, the market is consolidating and range bound. 

Furthermore, where the five lines are running parallel to each other, it is safe to assume that the market will continue in that direction. 

Support & Resistance 

Upper band of the prevailing cloud can act as an area of resistance while the lower band acts as an area of support. Where the current price breaks above the cloud this is akin to a breakout and below the cloud for a breakdown. This signifies a deep shift in market sentiment and the regular rules of supply and demand are in play.  

Crossovers

The Tenkan Sen and Kijun Sen lines can be used in a similar fashion to moving average crossovers. When Tenkan Sen crosses above Kijun Sen, this is considered a bullish signal. When Tenkan Sen crosses below Kijun Sen, this is considered a bearish signal. Many traders will enter and exit trades based on these crossover signals

Putting It All Together

Where price action is trading above the cloud and this is coupled with a bullish crossover of Tenkan Sen and Kijun Sen, this indicates a powerful buy signal. The probability of the trade is even further increased where price action is above the Chiku Span. Many traders will hold this position until Tenkan Sen crosses back below Kijun Sen. 

Is Ichimoku cloud strategy good?

The greatest strength of Ichimoku Cloud is that in just one glance, a trader can interpret a wealth of information. But don't forget that all indicators have weaknesses. The best way to combat these weaknesses is to understand, expect, and plan for them. We go through Ichimoku Cloud’s limitations below. 

Limitations Historical Data

While Ichimoku Cloud provides future leading lines these data points are calculated using historical data and are just projected into the future. There is nothing inherently predictive in the formula. It is still a lagging indicator. It is still playing catch-up to current price action. Where there are quick market reversals, the indicator may give off late signals. As always, backup Ichimoku Cloud signals with your own price action analysis. 

Trading Range 

Ichimoku Cloud is in its prime element in trending markets. However, when the markets are range bound and no clear trend exists, Ichimoku Cloud has a tendency to give off false signals. As explained above, it's still a lagging indicator so it may be slow to react to quick market reversals. As always, be cautious. Don’t just jump into a trade unplanned. Wait for the price correction. Test support and resistance levels and then enter a trade once there is a confirmation of trend. Even though you may miss out on the start of the trend, you will be less susceptible to false signals. 

Busy Charts

Ichimoku Cloud works best for the visual traders. However it is easy to get lost and feel overwhelmed by all lines and chaos. One thing we preach is to maintain clarity in your analysis, so one way to combat the ‘busyness’ of the chart is to focus on a set of lines at a time. Until of course, you become comfortable enough to glance at them and clearly understand their meaning. Most if not all charting software will allow traders to hide certain lines. If you’re looking specifically at the cloud and you find that the Tenkan Sen and Kijun Sen lines are distracting, get rid of them. Only include elements that are going to influence your trading decisions.

Where Ichimoku Cloud was once relegated to the list of ‘exotic indicators’, traders are now turning to Ichimoku Cloud as a sophisticated and effective way of evaluating the markets. Be mindful not to get too carried away. While Ichimoku Cloud can be a fantastic asset, no indicator should be used on its own. No matter how great a technical analysis indicator is, there is no replacement for watching price action and key areas of support and resistance.  

 

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