Technical analysis traders have many tools at their disposal to help make investing decisions. There are common ones like Bollinger Bands, moving averages and price patterns. In addition to these common tools there are an entire host of esoteric type technical tools like Gann Angles and the Ichimoku Cloud.
This article will provide the basics about the powerful technical indicator known as the Ichimoku Cloud. I like the Cloud since it is a no nonsense indicator. There is very little interpretation to using it.
The Ichimoku Cloud, also known as Ichimoku Kinko Hyo, appears to be very complicated at first glance by the majority of investors. In fact, just its name, causes many investors not to even explore its use.
Well, the truth is that the Ichimoku Cloud is a simple indicator that clearly defines support and resistance, trend, momentum, and gives trading signals. It is important to note that the Cloud’s complicated looking structure is what makes it so effective. It is not a common indicator so it provides a true edge to those investors who take the time to learn how to use it.
The Cloud was created by a Japanese journalist named by Goichi Hosod. Goichi first let the public know about his creation in his book published in 1969. It is somewhat soothing and confidence building to discover that the indicator was not invented by a math PhD or hedge fund quant. After all, how complicated can it be if a journalist created it?!
How Is The Cloud Created?
There are five lines on the Ichimoku Cloud chart at any given time so let’s review the indicators before looking at strategy
Four of the five plots within the Ichimoku Cloud are built upon the average of the high and low over a given period of time.
The Ichimoku Cloud consists of five plots:
1st Tenkan-sen (Conversion Line): (9-period high + 9-period low)/2))
The standard setting is 9 periods but can be altered. On a daily
chart, this line is the middle of the 9 day high-low range, representing close to 2 weeks.
2. Kijun-sen (Base Line): (26-period high + 26-period low)/2))
The standard setting is 26 periods but can be altered. On a daily chart, this line is the middle of the 26 day high-low range, reflecting nearly a month.
3. Senkou Span A (Leading Span A): (Conversion Line + Base Line)/2))
Senkou represents the between the Conversion Line and the Base Line
The Leading Span A reflects one of the two Cloud edges. It is
referred to as "Leading" because it is plotted 26 periods in the future
and forms the faster Cloud edge.
- Senkou Span B (Leading Span B): (52-period high + 52-period low)/2))
When plotted on the daily price chart, this line is the middle of the 52 day high-low range, representing close to 3 months. Just like the others, the default can be tweaked. This value is plotted 26 periods in the future and illustrates the edge of the slower cloud .
- Chikou Span (Lagging Span): Close plotted 26 days in the past
Obviously, this is plotted 26 periods in the past but just like the other 4 can be tweaked
Analyzing the Cloud
The Cloud is the most dominant feature of the formation hence the name. As you can see from the above chart, leading Span A (green) and Leading Span B (red) form the Cloud. The Leading Span A is the average of the Conversion Line and the Base Line.
Since the Conversion Line and Base Line are calculated with 9 and 26 periods, respectively, the green Cloud boundary moves faster than the red Cloud boundary, which is the average of the 52-day high and the 52-day low. It is the same principle with moving averages. Shorter moving averages are more sensitive and faster than longer moving averages.
How To Determine Trend Using The Cloud
One of the most important uses of any technical analysis tool is to determine trend. Knowing if the overall trend is up or down is the first step to making smart investing decisions.
There are 2 ways to determine trend using the cloud.
- Price
This is the most intuitive way to determine trend using the cloud. Just like with normal moving averages, if price is above the cloud, the trend is up. If price is below the cloud, the trend is down. Things really can’t be simpler!
- Red Cloud/ Green Cloud
Trend can be quickly determined with just one glance by noticing if the Cloud is red or green. A red cloud signals a falling market and is created when the leading span A is falling below the leading span B creating a red Cloud.
On the other hand, a green Cloud emerges when the Leading span A is climbing and above the Leading span B. The green Cloud is signaling a bullish or climbing market.
How To Trade The Cloud
The Ichimoku Cloud is a broad technical indicator that creates unambiguous signals. That is one of its strong qualities. Unlike many other technical indicators, the Cloud takes very little interpretation. Certainly, this does not mean that the Cloud is always correct in forecasting price direction, but one thing is certain, there is no ambiguity when interpreting.
The ways investors use the Cloud for making decisions can be many. The most basic way is to first verify the trend by using the Cloud.
Once an upward or downward trend is established, suitable signals can be determined using the price plot, Conversion Line and Base Line.
The most basic technical sign is when the Conversion Line crosses the Base Line.
Additional decision signals can be discovered when price crosses the Base or Conversion Line.
Just like with all technical indicators, always look for signals in the direction of the trend. Take an upward trend for example. In the case that the Cloud is signaling an upward trend, investors should look for pullbacks within the trend to enter in the upward direction of the main trend.
The opposite is also true during a Cloud signaled downtrend. When the Cloud reveals that the stock is downtrending, look for price to bounce higher to the resistance of the Cloud prior to entering shorts in an effort to capture the overall downtrend.
It is also very important to keep an eye on volume when it comes to using the Cloud to make investing decisions. Always try to make certain that volume is increasing in the direction of the trend. Keep your investment timeframe in mind when looking at volume. This is a mistake many investors make when it comes to volume. The longer your investment timeframe, the longer timeframe to look at volume. Studying daily volume changes when intraday trading makes no sense. Look at shorter timeframes for volume when day trading.
The same can be said for swing trading. Daily volume makes sense when you are swing trading.
I like combining the Ichimoku Cloud with fundamental analysis. Use the cloud to confirm that price is reacting in the correct way based on the fundamental data. If bullish fundamental data is released and the Cloud confirms the price movement, looking to get long is the smart move. The opposite can be said for bearish data