Introduction to the Ichimoku Cloud (or Ichimoku Kinko Hyo)

The Ichimoku Cloud (or Ichimoku Kinko Hyo) was developed by Goichi Hosada in Japan. His research started in the 1930s, but was halted by the world war.  He eventually completed it in 1968 whereby he published a 1000 page, 7 volume body of work.

When he did so, he did it under the pen-name Ichimoku Sanjin. The Ichimoku Cloud as a strategy and method for trading all instruments, is still growing in the Western and European regions.

Although it was originally built for the Japanese stock markets, it has since spread into the trading world at large, including Commodities, Futures, Options and the Forex markets.

The Ichimoku Cloud has been effective in its ability to find trends and reversals before they actual begin, so quite a powerful tool for trading.

The Ichimoku Cloud Components

The Ichimoku Cloud entails several components which enhances its versatility and uses. There are several main lines (5 in all).  The first two we will discuss will be the Tenkan-Sen (Sen = Line) and the Kijun-Sen.

The Tenkan Line/Sen (TL) is also referred to as the conversion line or turning line. It looks similar to a 9SMA, but is actually quite different. A Simple Moving Average (SMA) smoothens out all the data and makes it equal while the TL takes the highest high and the lowest low over the last 9 periods. This means it is based on the price action, but also includes volatility.

The chart below shows the TL quite different from the 9SMA. The TL is more representative of the price and reflects it clearly as it uses price instead of an averaging or the closing prices. As you can see below, the TL flattens in small quotas to move with price and its moments of ranging.

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Another important aspect is the angle of the TL. The sharper the angle, the stronger the trend and momentum is, while the weaker the TL angle, the flatter/lesser the momentum of the move.
Often times during a trend, it can act as the first line of defense or support in a trend. The breaking of the TL in the opposite direction of the move is often a sign of the trend weakening.

The Kijun Line/sen also known as the datum line, standard line or trend line formed to indicate the overall trend for the instrument or pair. The formula behind the Kijun-Sen is the same as that of the TL, using price action and the highest high + lowest low with the only change being in periods as it does over the last 26 periods.

Just as the TL, the angle of the Kijun Line mirrors the overall trend of the market. If the price action breaks the Kijun after being in an up/down trend, this usually represents a serious weakening of the trend.

Since price can often respect it during a strong trend, it can be used possibly as a stop loss for traders already in the correct direction of the trend. Thus, when the price breaks or closes below it by a significant amount, then the trend is usually considered over.
Applications for the Tenkan and Kijun

The most common application of the Tenkan and Kijun is the Tenkan-Kijun Cross Strategy (TKx). The TKx is one of the main signals for Ichimoku traders. It indicates when a trend is about to begin by forming a cross.

An upward cross signals a possible upward trend while a downward cross indicates a possible down trend. Moreover, a generic upward cross can be used as a bullish signal and a generic downward cross can be used as a generic bearish signal. The term ‘generic’ implies that there is more to the cross.

Goichi Hosada gave a further definition of the crossses on the basis of its position to the Kumo/cloud. The TKx is considered a ‘weak’ signal, when it is below the Kumo or below resistance.

It is considered a medium signal when the cross occurs inside the Kumo since it occurs within the field of support/resistance.

A strong signal is when the bullish cross occurs above the cloud since it happens after clearing resistance.

The reverse is true for bearish signals whereby a weak indicator is a cross above the Kumo, a medium indicator is inside the cloud and a strong indicator below the cloud.

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When trading the typical TKx signals, it’s also important to reference the construction of the cloud. The nature of the cross normally indicates the overall strength of the move. However, strong trends have also developed from weak crosses.

It is also crucial to reference the Chikou Span to see how the present price is in relationship to previous price action.

The Chikou Span, also referred to as lagging line is designed by taking the current closing price for the instrument and plotting it 26 time periods back. This concept is uncommon in technical indicators making the Ichimoku Cloud even more unique.

The purpose of this is to reflect how the current price action is in relation to the previous price action. Thus, it is important to look at how the chikou span relates to current price action and past price action.

If the Chikou Span is lower than price 26 time periods ago, then there is resistance for the current up move which could force price down into a bearish move. However, if the Chikou Span is above price of 26 periods ago, then there could be little or no resistance ahead since the price is about to make new highs paving way for a strong trend.

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The Kumo or Cloud
Probably the most unique component of the Ichimoku Kinko Hyo is the ‘Kumo’ or cloud which offers a unique perspective of support and resistance.

Most western methods deal with the support and resistance in a linear fashion. For example the Fibonacci lines, Pivots, Channels, and Trend Lines are as all used as straight lines. However, the kumo/cloud is an ever evolving entity designed to look at support and resistance based upon previous price action.

Usually, when in a strong upward trend, the support is strong since the price levels below have been breached and will no longer act as resistance but now support the underlying trend. This is the opposite for a strong downtrend. As a general rule for the Kumo, when the Kumo or cloud is thick, it means the support or resistance is strong.  If price is above the kumo, then the kumo acts as support.  When price is below the kumo, it will act as resistance.

Below is a good example of how during a strong uptrend, the Kumo is thick and acts a solid support in a pullback before the trend continues.

Image 1.1

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In the next image below (image 1.2), we can see how the Kumo acts as resistance where price cannot penetrated above the kumo before continuing the sell-off.

Image 1.2

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The most essential way to view the cloud is from a support and resistance perspective, meaning it acts as support and resistance. If the Kumo is thick, then the support/resistance is strong.

If price is below the Kumo, then it is below resistance and we will be searching for more shorts than longs. If price is above the cloud, then there is an uptrend likely in place, and therefore we will be looking for more buying opportunities. The longer price stays below/above the cloud, the stronger the trend we are in and the more support/resistance the kumo will offer.

General Composition of the Kumo

The cloud consists of two main lines which are referred to as Senkou Span A and Senkou Span B. It is the space/value between these two lines is what we refer to as the Kumo.

Span A is created by taking the Tenkan Line value, and adding it to the Kijun Line value, then dividing that value by 2 and plotting it 26 periods ahead. This can be expressed as: (Tenkan Line + Kijun Line)/ 2 placed 26 periods ahead.

Span B is created by taking the highest high, adding to it the lowest low, then divide it by 2 and plotting that 26 time periods ahead. This can be expressed as: (Highest High + Lowest Low for the last 52 periods)/2 and plotted 26 time periods ahead.

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Some Important Notes on the Kumo and the Kumo Break Strategy

The Kumo is designed to represent support and resistance; however, it has a host of implications regarding the price action and current trend.

As stated earlier, the thicker the cloud, the stronger the support/resistance is in place. Price would often reject off the Kumo only to resume the current trend as illustrated before.

On the other hand, if the Kumo is extremely thin and there is no trend, a range is likely to continue since there is neither enough support nor resistance to hold a single direction for the pair.

This also implies that if we are in a current trend and price is approaching a thin Kumo, the likelihood increases for a trend reversal because the support/resistance in place by the Kumo is weak. Thus, Kumo analysis is vital for ichimoku trading since it can often lead to reversals and inform us traders of pending trend changes in the future.

Kumo Flat Top/Bottom

Another common formation in the Kumo is the ‘flat top or bottom’. This is when the Span A or Span B becomes flat.

Span B consists of the last 52 candles absolute highest high and lowest low / 2, thus referring to price action over the last 52 periods. If Span B is flat, then price has not extended to make any new significant highs or lows. This implies that we are in a ranging market.  Therefore, the tendency of the trend is to move towards equilibrium, or towards the center of the range (value area for price).

Thus, it can also be said that the span B is the virtual 50% fib retracement level for that range and is the ever changing 50% fib level for a trending market, dividing the last 52 candles into two halves, the upper and lower half.

Another thing to note about the flat top/bottom formation is price action will have an inclination to move towards the flat top/bottom. If price is above the Kumo, the tendency of price will be to move towards the flat top. This is often used as a springboard for a rejection off of the cloud.

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Finally, another important aspect of the Kumo is what happens when the price breaks it. This is referred to as a Kumo Break.

If there were a strong trend in place for some time, and then price breaks the Kumo, usually this means we have a trend change with a large move likely heading in the direction of the break.

You can see this in the examples below.

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Thus as a whole, we can see the Kumo represents a much better perspective of support and resistance since it is always changing shape. It is essentially based upon price action instead of some fixed lines in the sand.

This means it can be more sensitive and representational to price than static forms of support and resistance which do not move once in place. Its unique construction allows the Kumo to be both Static and Dynamic in providing support/resistance levels to the trader.

In Conclusion

The Ichimoku Cloud has an excellent ability to detect trends, reversals, support/resistance levels, trend strengths/weaknesses and momentum for a pair. Combined, these enable the Ichimoku Cloud to be highly effective as a strategy, along with offering a unique perspective of price action. To learn more about how to trade various Ichimoku Cloud strategies, visit the Ichimoku Course where you can learn rule based methods to trade trends, reversals and breakouts using the Ichimoku Cloud.