Reading a Cloud Chart

In a recent post, we introduced Cloud Charts, formally known as Ichimoku Clouds. We received several questions about how to interpret the charts. While we generally like to provide answers to questions in the comments section of the blog, some answers require more space than that. When more space is needed, we sometimes devote a post to the question as we are doing now.

Rather than cover Clouds in detail here, we will provide a quick review. The chart is visually distinctive.

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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 Cloud 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.

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Now let’s look at how to analyze the chart of Apple (Nasdaq: AAPL) shown above. It can be confusing to look at the chart because there are several pieces of information. With experience, many traders like having a large amount of information available at a single glance. With less experience, the chart can be overwhelming. To cut through potential confusion, we will look at that chart in three steps. In the first step, we will look only at the clouds and then we will address the interpretation of the various lines.

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Because the chart is less confusing, we have compressed the time to show more signals. With just the Clouds, interpretation is easy. When prices are above the Cloud, the chart is bullish. When prices are below the Cloud, the chart is bearish. When prices are in the cloud, the answer is not clear but we should expect the previous trend to resume. Right now, prices entered the Cloud from below so we should expect AAPL to resume its downtrend.

The chart above shows these signals are clear enough that they can be traded. Sell when prices fall below the lower span of the loud and buy when prices break above the upper line of the Cloud. This is similar to a trading strategy using moving averages (MAs). One problem with any MA is that signals come after the trend has reversed and you need to capture long-term trends to make up for the delays in the signals. Another problem with MAs is that there will inevitably be a number of whipsaw trades. A whipsaw trade is one that lasts a short time before being reversed. These trades usually result in small gains or losses but trading costs can add up. These costs are generally overcome with an MA strategy because you will eventually be on the right side of a long-term trend.

Clouds should also deliver profits from long-term trends but they will suffer from lags in signals and whipsaw trades while waiting for the big winners that are generally needed to make a trend following system successful.

This is an important point. Any individual trading decision based on Clouds can be wrong. There could be several losing signals in a row. It generally requires discipline to take 100% of the signals and a long-term commitment to profit from Clouds or any trend-following strategy.

In the chart above, we see that AAPL dropped below the lower line of the Cloud in the middle of November. This is bearish and it will take a break above the upper line of the Cloud for AAPL to turn bullish with this indicator.

The next chart removes the Cloud Spans and includes only the Turning Line and the Signal Line.

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These lines are moving averages and should be interpreted in the same way any MA would be interpreted. When the faster moving average is above the shorter average, the chart is bullish. In this case, that would mean the Turning Line is above the Standard Line. When the shorter MA is below the longer MA, the chart is bearish. In the chart above, the Standard Line, the longer moving average that uses 26-bars instead of 9 in its calculation, is shown in red. In the chart above, when the red line is on top, the chart is bearish. We often use this convention when drawing charts because in general, “red is bad” and having the sell signal appear in red makes the information easy to see.

From the chart above, you can see this system does a nice job providing buy and sell signals. Right now, AAPL is bearish on this reading.

The next chart shows the Lagging line. This is meant to confirm the trend.

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To interpret this signal, we look for crossings of the distant span of the Cloud. The most recent signal occurred when the Lagging Line broke above the Cloud in June. For now, it will take a break below about $106 for a new sell signal. While the other two aspects of the Cloud are bearish for AAPL, the Lagging line is bullish.

Traders can use Clouds in a number of ways. They could take trades when all three signals agree. An example of this can be seen in the weekly chart of AAPL.

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This chart highlights a dilemma traders always face in deciding which time frame to chart. As we saw, in the daily chart, two of the three Cloud signals are bearish for AAPL. In the weekly chart, all three signals are bullish. Ideally, we would like to see both time frames agree but that won’t always happen. Requiring both time frames to agree will reduce the number of trading opportunities. It might be best for traders to decide if they want to be long-term investors using weekly charts or short-term traders using daily or intraday charts and then restrict their analysis to the desired time frame.

If using the daily chart, in this case, a trader would most likely be neutral on AAPL. They might decide they would buy when all three signals agree and sell when one or two signals turn bearish. Aggressive traders could short the stock or buy a put option to potentially benefit from a decline if all three signals are bearish.

If using the weekly chart, the trader would be long AAPL.

Many traders will prefer a simpler approach than Clouds. A simple MA system, maybe buying when the 50-day MA crosses above the 200-day MA and selling on a downside cross, could be easier to trade. There would be only one signal to watch in that system. With Clouds, traders have three signals to watch:

  1. Relationship of the closing price to the Cloud Spans; if the close is above the Clouds, the signal is bullish and when the close is below the Clouds the signal is bearish.
  2. The position of the Turning Line to the Standard Line.; when the Turning Line is above the Standard Line, the signal is bullish and when the Turning Line is below the Standard Line the signal is bearish.
  3. The position of the Lagging Line to the Cloud Spans; buy signals are given when the line is above the Cloud and a sell signal is given when the line is below the Cloud.

As noted, you can trade when all three signals agree or when two of the three agree or in some other way. You could also pick one of the three signals and base all decisions on that indicator, ignoring the other components of the Clouds. The important point, as it is with any indicator, to apply the same rules consistently. If you are consistent and disciplined, Clouds could deliver gains in the long run.