Ichimoku Kinko Hyo – also known as the Ichimoku Cloud and often abbreviated to just Ichimoku – is a versatile indicator that can be used in various markets. It sometimes gets called the Ichimoku indicator.
Initially adopted by Japanese commodity and stock market traders on its debut nearly 50 years ago, Ichimoku is multi-purpose and can define support and resistance, identify trend direction, gauge momentum and provide trading signals.
Support and resistance levels are horizontal price levels connecting price bar highs to other price bar highs – and lows to lows – forming horizontal levels on a price chart. A support or resistance level forms when a market’s price action reverses and changes direction, leaving a peak or trough in the market. Support and resistance levels typically contain price movements, but eventually the price is likely to break through them.
Support and resistance are important to the momentum investor as signals of future price movement. Momentum investing can appear more like a knee-jerk response to market information than an investment strategy. However, momentum investment guru Richard Driehaus argued that more potential profit lay in ‘buying high and selling higher’ than buying under-priced stocks and waiting for the market to re-evaluate them. Instead, he opted for selling losers and letting the winners ride, with money from the losers re-invested in other, more promising stocks.
As a visual technical analysis system, Ichimoku employs a range of indicators that when combined together create a visible system for traders to quickly and easily gain perspective on the overall direction of a share or share index. It helps to identify higher probability trade opportunities and distinguish them from those of lower probability.
Ichimoku = one glance; Kinko = equilibrium or balance; and Hyo = chart – so the phrase translates as ‘once glance equilibrium chart’, meaning that traders can determine momentum, support and resistance with just one look. The chart consists of five lines: these are the Tenkan-sen; Kijun-sen; Senkou Span A; Senkou Span B; and Chickou span.
Years in development
The Ichimoku system was the brainchild of Japanese journalist Goichi Hosoda, known to his friends as Ichimoku Sanjin, which translates as “what a man in the mountain sees”. As a reporter on the old rice trading markets just before the Second World War, he noted how the commodity’s price followed certain rules and reacted around certain areas of the chart. The movements were due to what has become known as support and resistance.
Hosada embarked on devising a single indicator for viewing and analysing the years of price movements, a project that was to occupy him for 30 years.
Back in the 1940s, when the very first commercial computer was still on the drawing board, this work could only be accomplished by employing a group of students to manually back-test a variety of price movements, structures and formulas. The Ichimoku Kinko Hyo indicator wasn’t completed and ready to present to the Japanese public until 1969, when it quickly became the indicator of choice used in Japan’s trading rooms.
It took a further two decades for Ichimoku to gain serious attention in Western markets. Eventually though, its versatility and potential for gauging both future price momentum and future areas of support and resistance was recognised by stock market traders around the globe. The Ichimoku indicator can appear alarmingly complex at first glance, but, as has been remarked on, it was created by a journalist and not a rocket scientist.
Experienced traders quickly became accustomed to its five lines – briefly outlined below – and thepurpose that each one serves. Although envisaged as an all-in-one indicator, Ichimoku is typically used by traders in combination with other forms of technical analysis.
The five constituents
The five key components of the Ichimoku trading system can be described as follows:
Tenkan-sen – also known as the turning line, this calculated by the average derived from adding the highest high and highest low for the past nine sessions and dividing the total by two. The turning line that results represents a key support and resistance level and also a signal line for reversals.
Kijun-sen – aka the standard line or base line, this is calculated by averaging the highest high and the lowest low for the past 26 periods. The resulting line represents a key support and resistance level, a confirmation of a trend change, and can be used as a trailing stop loss point.
Senkou Span A – the first Senkou line is calculated by adding the Tenkan-sen and the Kijun-sen, dividing the result by two and then plotting the result 26 periods ahead. The resulting line forms one edge of the kumo – or cloud – used for identifying future areas of support and resistance.
Senkou Span B – the second Senkou line is determined by averaging the highest high and the lowest low for the past 52 periods and then plotting the result 26 periods ahead.The resulting line forms the other edge of the kumo used to identify future areas of support and resistance.
Chickou Span – also called the lagging line, this is the current period’s closing price plotted 26 days back on the chart. The line is used to show possible areas of support and resistance.
Each of these lines is colour coded –
Tenkan sen: Red line
Kijun-sen: Blue line
Senkou Span A and Senkou Span B: Orange lines
Chickou Span: Green line
Ichimoku trading strategies
How does each of this quintet work in practice? The Tenkan-sen is an indicator of the market trend – when the red line moves up or down, it indicates that the market is trending, while a movement horizontally signals that the market is ranging. The Kijun-sen acts as an indicator of future price movement: when the price rises above the blue line, it could continue to climb higher and when the price is below the blue line, it could keep dropping.
As for the Chikou Span, when the green line crosses the price in the bottom-up direction it acts as a ‘buy’ signal, but when the line crosses the price from the top-down it’s a signal to sell.
So once the trader has confirmed a trend by recognising price as being below or above the kumo (cloud), they can go on to the moving averages. The most basic theory of the Ichimoku is that when the price is above the cloud, the overall trend is bullish; below the cloud is bearish; and in the cloud is non-biased or unclear.
Lastly, when the price is above the cloud then the top of the cloud will act as a general support level. When it is below, the cloud base will act as resistance. However, a note of caution is needed here – the cloud has thickness, as does resistance too, so making these thicker reduces the risk of a false breakout.