Using the Ichimoku Cloud to discover Reversals
The most unique thing about the Ichimoku cloud is the actual cloud/kumo. By itself, the kumo was created to represent support/resistance, but seen through the lens of them being evolving or dynamic, and not static like pivot points, Fibonacci lines, support lines or trend lines.
The inventor (Hosada) saw that support/resistance was evolving and actually based upon the previous price action. Specifically, Hosada had great concern with the highs and lows (along with the closes and opens) of previous price action which exhibited levels of rejection where the market would not accept price. The prior highs and lows also give traders the range where the market accepts price.
The construction of the Cloud/Kumo will illustrate how the Ichimoku Cloud represents support and resistance.
The Kumo is comprised of two key lines referred to as the Senkou Span A and Senkou Span B. Herein, we will refer them to as Span A and Span B respectively. The space enclosed between these two lines is what forms the cloud/Kumo.
Span A is generated by finding the average of the Tenkan Line (TL) and the Kijun Line (KL), and placing it 26 periods ahead. The formula is; (TL + KL)/2 plotted 26 periods ahead.
Span B is created by finding the average of the highest high (HH) and lowest low (LL) over the last 52 periods and plotting it 26 periods ahead. The formula is; (HH + LL over the last 52 periods)/2 and plotted 26 periods ahead.
Before we proceed to the construction of the Kumo, we need to understand the Tenkan and Kijun lines which help in forming the ever changing Span A.
The Tenkan Line (TL) or Tenkan Sen (Sen Meaning line in Japanese) is also known as the conversion line or turning line. It is similar to a 9SMA but actually very different. A simple moving average (SMA) smoothens out all the data and makes it equal but the TL takes the highest high and lowest low over the last 9 periods. Hosada felt that price action and its extremes were more important than smoothing any data. The chart below shows the TL being quite different from the 9SMA. The TL reflects price better and is more representative of it, since it uses the price instead of an averaging or closing prices.
The Kijun Line (Kijun Sen) is also known as the datum line, standard line or trend line formed to show the overall trend for the pair. The formula behind it is the same as the TL using price action and the highest high + lowest low with the difference being in the periods only; it does it over the last 26 periods. An example is in the chart below.
As a general rule, if the Kijun has been rising, then price has been gaining ground for the last month (approximately). This would be the opposite if it was falling. On the other hand, if it is flat, then it represents the price equilibrium for the last month of price action.
Construction of the Kumo
Formation of the Span A
Span A is formed by finding the average of the Tenkan Line (TL) and the Kijun Line (KL), and placing it 26 periods ahead. The formula is; (TL + KL)/2 plotted 26 periods ahead.
Therefore, the TL which is the momentum line, and the Kijun line which is the trend line, are moving based on price action. Finding the average of their values and plotting the result 26 periods ahead is what forms the Span A.
Thus, one of the underlying tenets of the Ichimoku Cloud is based on evolving price action lines which are half momentum and half trend monitoring. Putting these halves together we obtain the Span A which always changes depending on the acceleration or deceleration of price based upon how they affect the Tenkan/Kijun lines – and the Span A.
Moving on to the second line, the Senkou Span B, which is slightly different and based only upon price action, particularly the last 52 candles of whatever time period you are dealing with.
If you are on a daily chart, then we are talking about the last 52 days; for a 1hr chart, then the last 52 hours of price action are considered. After taking the high and low for the last 52 candle range, it adds their values, divides them in half, and places them 26 time periods ahead.
The shaded space in between Span A and B is called the Cloud or Kumo which you can see in the chart below.
Since the Ichimoku Cloud/Kumo represents support and resistance, then the thicker the Cloud, the stronger the Support/Resistance it offers. If price is below the Kumo, then it will act as a resistance and if price is above the Kumo, then it will act as support. The Cloud can take many forms and shapes (virtually infinite) which is what makes it complex; however, the thick Kumo is often will reject price and the longer the time frame (4hr, Daily, Weekly), the more powerful the Kumo will act as S/R.
See the examples below.
USDJPY 4hr charts
You can see how the pair rejects off the really thick cloud; however, reverses where the cloud was the weakest or thinnest.
USDCAD 4hr charts
In another example, after the USDCAD’s initial fall, it rejects off a really thick Kumo twice telling us a reversal of the trend was less likely. Nevertheless, the Kumo starts to thin out indicating a break through the kumo and likely reversal point.
Therefore, a clear tactic in using the kumo for reversals is to look for a kumo break. One method is to look for thinnest cloud formations which signal for a potential upcoming reversal.
Since the Kumo is placed 26 time periods ahead, we have adequate time to notice when the signal or potential kumo break is coming. When you are in the current trend, the kumo window (weak/thin point in the kumo) can be a warning signal to take profits. Another alternative is if you are looking for a reversal, then the cloud offers a good position and method to time a reversal.
Another hint hidden in the cloud can be the flipping of the Span A and B which indicates a reversal but not always. The other main point is that price does not always reject off a thick cloud; hence, it is important to also watch price action but the Ichimoku Cloud and kumo is highly effective at spotting and timing reversals.
For more information on how to trade Kumo Breaks using rule based systems, make sure to visit the Advanced Ichimoku Course to learn more about the Ichimoku Cloud, or proprietary quantitative data based strategies on the Ichimoku.