Clouds Can Help Traders Spot Trends

Technical analysis is an established discipline dating back to at least the 1800s. Some techniques are even older with candlestick patterns being used to trade rice markets in eighteenth century Japan according to legend. However, candlesticks were lost for centuries to Western traders and only became popular after they were reintroduced to the world in the 1980s. They were brought to the attention of traders in Western markets by Steve Nison in his book, Japanese Candlestick Charting Techniques, and Nison noted that based on his research, he believed the chart style was developed after 1850. While the exact history is unknowable, it is interesting that there was a high degree of interest in markets in Japan when Nison published his book. This might explain why candlesticks achieved instant acceptance and are now the default setting for many charts.

Japanese markets were largely closed to Western investors until about the 1980s. Their opening came as the great bull market in that country was coming to an end. For decades prior to that opening, the relative isolation of the markets seems to have forced traders in Japan to develop their own analytical tools. Candlesticks are one example. In recent years, another technique from Japan has been reintroduced to the trading world. Ichimoku Clouds were developed in Japan beginning in the 1930s and have been explained to traders in the West with several books published in the past few years.

The technique is formally known as “Ichimoku Kinko Hyo” which translates to “one look equilibrium chart.” This phrase summarizes the goal of the developer, Goichi Hosoda, a journalist who spent more than thirty years working on the technique. Hosoda started working on his system before World War II after enlisting a number of students to run through various formulas in an early application of back testing and optimization. Hosoda had a number of ideas and his students did the work of the computer. The Ichimoku system was first published in 1968 and gained some degree of popularity in Japan and Asian markets. It has only been in the past few years that translations of the system became available to traders in the West.

Ichimoku Cloud charts are designed so that traders can identify the direction of the trend with one look. Traders can also spot important price levels to watch in the future that will tell them when the trend has most likely reversed.

At first glance, Cloud charts can look confusing and intriguing. The chart below is taken from StockCharts.com where the charting style is available for free. You can also find these charts at a number of other web sites. Below is a daily chart of SPDR S&P 500 ETF (NYSE: SPY) with all of the components of the Cloud system.

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The most prominent feature on the chart is the shaded areas. These are the clouds. There are actually five components of the chart and the construction of the Could Chart can be summarized as follows:

  1. Turning Line, which is the midpoint of the high and low of the last 9 sessions.
  2. Standard Line which is the midpoint of the high and low of the last 26 sessions.
  3. Cloud Span A is the midpoint of the turning line and the standard line and is shifted forward by 26 bars.
  4. Cloud Span B is the midpoint of the high and low of last 52 sessions and is also shifted 26 bars forward.
  5. The Lagging Line is the price line the (the closing price) shifted backwards by 26 bars.

Each of these components is also known by other names. The Turning Line is called the Tenkan-sen or the Conversion Line in some sources. The Standard Line is the Kijun-sen or Base Line. The Lagging Line is also known as the Chikou Span or the Lagging Span.

The lines forming the clouds also have several names. Cloud Span A is also known as the Senkou Span A or Leading Span A. This line forms one of the two Cloud boundaries. It is called “Leading” because it is plotted 26 periods in the future. Cloud Span B, also known as the Senkou Span B or Leading Span B, is also plotted 26 periods in the future.

When Cloud Span A is above Could Span B, the area between the two lines is shaded in green. Red shading is used when Cloud Span B is above Cloud Span A.

While there appears to be a lot of lines in the chart, the interpretation of the Clouds is actually fairly straightforward:

  • Prices above the cloud indicates a bullish picture.
  • Prices below the cloud indicates a bearish trend.
  • Prices in the cloud are bullish if they came from the bullish zone (above the cloud).
  • Prices in the cloud are bearish if they came from the bearish zone (below the cloud).
  • Historically thick clouds after a run up in price might signal an imminent trend change.
  • The Lagging Line crossing the cloud confirms that a trend change has occurred.

These rules explain the idea of “one glance” chart interpretation. At a glance, traders will know whether prices are above or below the cloud. If they are in the cloud, the preceding trend will be easy to spot. The thickness of the clouds is also easy to spot. In the chart above we can see the cloud is thickening as prices topped.

The Lagging Line can be difficult to spot in the clouds. In the next chart, the other lines have been turned off to allow for an easier interpretation.

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Here we can see the Lagging Line confirmed the bearish outlook as prices were topping. The Lagging Line also quickly reversed course and confirmed a buy signal in the subsequent rally.

A test of any strategy traders should consider is a review of how it would have performed in 2008. That was, of course, a devastating bear market that many traders failed to avoid. Ichimoku Clouds clearly provided a sell signal near the top as the chart below shows. This sell signal came after prices had turned down which made it easier to take action. Many moving averages gave signals months before the down move started and missed out on the last gains of the bull market. For traders, from a practical perspective, it is difficult to sell when prices are still rising. Ichimoku Clouds gave a signal that would have been relatively painless to follow.

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Perhaps more importantly traders should be interested in how quickly a buy signal was generated after the March 2009 bottom. That information is noted in the chart above. The buy signal came just 21 trading days after the bottom, after prices had risen about 26%. Because the bottom had been so sharp, longer-term moving averages signaled buys after prices had risen 40% or more and missed a significant part of the recovery.

There is no way to avoid all of the downside of a bear market and then capture all of the upside of the bull market but Ichimoku Clouds provide a nice balance between those two objectives.

Clouds are now readily available to traders and they can provide important information to trader. They could be used to confirm other indicators or they can be used as a standalone trading system. Either way, traders should consider using them as a tool to identify the direction of the trend.