Demystifying the Ichimoku Cloud
Still growing amongst the Western and European traders, the Ichimoku Cloud (or Ichimoku Kinko Hyo = One Glance Balance Cloud Chart) was originally developed pre-WWII by a man named Goichi Hosada. Because of the war, his research was halted and then later finished in 1968 whereby he published a 1,000 page, four volume body of work releasing the Ichimoku Cloud to the world under the pen name Ichimoku Sanjin.
Originally built for the Japanese stock markets, the indicator has made its way out of the land of the Eastern sun and into the trading world at large, being applied and used widely in the Commodities, Futures, Options and FOREX markets. Part of its success is its ability to find trends and reversals well before they begin.
The Ichimoku Cloud has several components that give it a lot of versatility and uses. The most unique aspect of the indicator is its 'Kumo' or cloud, which offers a unique perspective of support and resistance. Most western methods look at support and resistance in a linear fashion or as straight lines in the sand (e.g. Fibonacci, Pivots, Channel Lines, and Trend Lines). However the Kumo or cloud is an ever-evolving object that was designed to represent support and resistance based upon price action. Generally, when you are in a strong upward trend, the support is strong as the price levels below have been accepted. The same goes for a strong downtrend and having more layers of resistance. Below are two examples of up and downtrends - showing how the Kumo was quite thick in nature.
The most important way to look at the Kumo is as support and resistance - meaning if it is thick, then the support/resistance (depending upon where price is in relationship to the cloud) is strong. If price is above the Kumo, we are in a general uptrend or would want to look for more buying opportunities. If price is below the cloud, it is below resistance (the Kumo) and we want to be searching for more shorts than longs. The longer price stays below/above the cloud, the stronger the trend we are in and the more support/resistance the Kumo will offer.
There are two main lines of the Kumo, which are referred to as Senkou Span A and Senkou Span B. For the purposes of efficiency, we will refer to them as Span A and Span B. The space, or value, in between these two lines is what forms the Kumo.
Span A is formed by taking the Tenkan Line and adding it to the Kijun Line (white and red lines respectively from chart above), then dividing that value by 2 and plotting it 26 periods ahead. The formula is:
(Tenkan Line + Kijun Line) / 2 placed 26 periods ahead.
Span B is formed by taking the highest high (over the last 52 periods), adding to it the lowest low (over the last 52 periods), dividing that by 2 and plotting that 26 time periods ahead. The formula is:
(Highest High + Lowest Low for the last 52 periods) / 2 and plotted 26 time periods ahead.
We will talk about some important points regarding the construction of the Kumo later.
Other Ichimoku Components (Tenkan, Kijun and Chikou Span Lines)
The Tenkan Line or Tenkan Sen (Sen is Japanese for line) is known as the conversion line or turning line, and is similar to a 9SMA but actually is quite different. Remember a SMA (simple moving average) will smooth out all the data and make it equal but the Tenkan Line will take the highest high and lowest low over the last 9 periods. The explanation for this is Hosada felt price action and its extremes were more important than smoothing any data because price action represented where buyers/sellers entered and directed the market, thus being more important than averaging or smoothing the data out. As you can see by the chart below, the Tenkan Line is quite different than a 9SMA. Because the TL (Tenkan Line) uses price instead of an averaging or the closing prices, it mirrors price better and is more representative of it. You can see this when the TL flattens in small portions to move with price and its moments of ranging.
Akin to all moving averages, the angle of the Tenkan line is very important as the sharper the angle, the stronger the trend while the flatter the Tenkan, the flatter or lesser the momentum of the move is. However, it is important to not use the Tenkan line as a gauge of the trend but more so the momentum of the move. However, it can act as the first line of defence in a trend and a breaking of it in the opposite direction of the move can often be a sign of the defences weakening.
The Kijun Line (or Kijun Sen) is known as the datum line, standard line or trend line designed to indicate the overall trend for the instrument or pair. The formula behind it is the same as the Tenkan line using price action and the highest high + lowest low with the only change being in the periods as it does it over the last 26 periods.