The financial trading world has benefited a lot from the ingenuity of the Japanese trading experts.
Many of the most popular tools we use in trading — from chart types, like the Candlestick, Renko, Kagi, and Heiken Ashi charts to trading indicators like the Ichimoku — come from the Japanese.
The Ichimoku indicator is considered to be one of the most comprehensive trading indicators because it can be used as a complete trading system on its own.
With several components that help you identify the trend and when to enter and exit a trade, Ichimoku is a complete trading toolbox within one indicator.
The indicator overcomes the difficulty of trying to use different indicators to build a trading system, as it helps you to understand market movements at first glance.
Interestingly, it is one of the standard indicators that are available in all popular charting platforms.
In this post, we will discuss the components of Ichimoku, how to interpret them, and the best way to use them in finding trading opportunities. But, first, let’s find out how the indicator came about.
How the Ichimoku indicator came about
Ichimoku, or Ichimoku Kinko Hyo, when written in full, was initially developed by a Japanese journalist, Goichi Hosoda (1898-1982) and published in his 1969 book.
As at then, Goichi Hosoda was a financial market reporter for the Capital Newspaper.
Roughly translated to English as “a glance at a chart in equilibrium”, the Ichimoku indicator was developed to help traders get a better understanding of the market condition at the shortest possible time and be able to pick better trading opportunities.
Although the indicator was gaining popularity when the author was alive, after his death in 1982, it fell out of use.
The method came to life again in 1996 when Hidenobu Sasaki, a trader from Nikko Citigroup Securities, released a book titled, “Ichimoku Kinko Studies”.
With the popularity that came with the new book, institutional traders started using the method — in fact, it became the go-to method for most trading desks of Japanese banks and other financial houses.
Even the Japanese branches of American banks were not left out, and with time, they introduced it to their U.S. counterparts.
Before you know it, there was a widespread adoption of the method in the US and the rest of the western world.
Even though banks and institutional traders were the first groups to start using the method, it is almost impossible to see a broker that does not have the Ichimoku indicator in their charting platform.
As a retail trader, you should also add the indicator to your toolset and learn how to make use of it in your trading.
Thus, we created this post to show you the things you need to know. So, let’s find out what the indicator is about.
What is Ichimoku Kinko Hyo?
Ichimoku Kinko Hyo is an informative, all-in-one technical indicator that provides reliable support and resistance levels; shows the direction of the prevailing trend; gauges the strength and momentum of a trend; and gives reliable trade signals. You can find it in virtually every charting platform.
The name, Ichimoku Kinko Hyo, actually describes the philosophy of the indicator as a trading system. This is how the name breaks down in English:
-Ichimoku = “at first glance”
-Kinko = “balance or equilibrium”
-Hyo = “graphical representation or chart”
Just as the name implies, the indicator shows you everything you need to know about the state of the market.
With one glance at the chart, you can see who is in control — the bulls or the bears — and the direction the market is likely headed.
Ichimoku is a very versatile and informative trading indicator, but you can easily feel overwhelmed by the nature of the indicator if you don’t know how to interpret the various lines and shades.
The indicator is made up of 5 lines, which we will discuss in detail in the next section.
The default settings in the indicator are 9, 26, and 52, and those values reflect the ancient Japanese work week.
As of then, the Japanese work 6 days a week. So, the 9 periods imply 9 trading days or one and a half weeks; the 26 implies the 26 trading days in one full month; while the 52 implies the trading days in two full months.
The components of Ichimoku
The Ichimoku indicator comprises of 5 lines and 4 distinct parts :
- Tenkan Sen
- Kijun Sen
- Kumo
- Chinkou Span
Tenkan Sen or Conversion Line (blue line)
The Conversion Line represents the midpoint of the range of the last 9 candlesticks (last 9 periods).
To get this midpoint, the highest price level and the lowest price level in the last 9 periods are added and then divided by 2.
Being a continuous line, the calculation continues with each new period, provided there is a change in the range of the last 9 periods.
While the line may seem like a moving average line, with the slope also indicating the momentum of price movement, the Conversion Line is actually different.
A moving average uses the specified price point for all the candlesticks in the last 9 periods in its calculation, as such, the line is smoother.
For the Tenkan Sen, only the highest and lowest price levels in the last 9 periods are used.
Thus, if the last 9 periods maintain the same highest and lowest levels, the line will stay flat, which shows that the price is not currently trending.
Kijun Sen or Base Line (dark-brown line)
The Base Line is derived from the midpoint of the range of the last 26 periods or candlesticks.
To get this midpoint, the highest price level and the lowest price level in the last 26 periods are added together and then divided by 2.
The calculation continues with each new period, provided the price is making a new high or low.
As you can see, the period considered in the Base Line is longer (a full trading month if it’s on the daily timeframe).
Thus, it can show where price movement is stalled for a long time, indicating temporary support and resistance levels.
Looking at the Base Line, you can see, at that moment, where the price is in relation to potential support or resistance level.
Just like the Conversion Line, the Base Line is different from a 26-period moving average because of the way it is computed — the midpoint of the latest 26-period range, rather than the average of the data points in each period.
Chinkou Span or Lagging Span (yellow line)
As the name suggests, Chinkou Span lags behind the price. It is actually the closing prices plotted 26 periods back.
Often described as the market memory, it juxtaposes the current closing price with the price action of 26 periods ago so that you can easily compare and know which stage of the price cycle the price is currently at. It can also show you previously stubborn levels which the price has to cross again.
Kumo or Clouds
The cloud is made up of 2 lines — Senkou Span A and Senkou Span B — and the shaded space in-between them, and it is projected 26 periods into the future.
Senkou Span A or SSA (green line)
This is the faster-moving boundary of the cloud. It is derived by computing the middle between the Conversion Line and the Base Line and then projecting the result 26 periods into the future.
Since it takes the middle point, it reflects the equilibrium between short-term and long-term price actions.
By projecting the result into the future, it makes important price levels visible which can act as reference points as the price cycles up and down.
In other words, it projects potential dynamic support and resistance levels into the future.
Senkou Span B or SSB (red line)
This is the slower-moving boundary of the cloud, it is derived from the midpoint of the most recent 52-period range.
It is computed by adding the highest price level and the lowest price level in the last 52 periods and then dividing by 2. The result is then projected 26 periods into the future.
Just like the SSA, it is projected into the future to create visible important market levels that can act as dynamic support and resistance levels.
The way the price reacts at those levels, as it cycles up and down, can indicate the intention of the price action.
The cloud (shaded green or red)
This is the space between the SSA and SSB lines, and it’s often shaded in a color that matches the line lying on top.
When the SSA is above the SSB, the cloud has a bullish color — green is often used.
On the other hand, when the SSA is below the SSB (the SSB is on top), the cloud takes a bearish color, which is usually red.
Since the SSA is derived from the Conversion and Base lines, which are of a shorter period than the SSB, it is more reactive than the SSB.
So, the size of the cloud is more dependent on the movement of the SSA, as this line can speed away from the SSB.
When the SSA crosses the SSB, it is called a twist, and it happens when a trend is about to change direction.
How to interpret the signals from Ichimoku components
Ichimoku is a complete technical analysis tool that takes a long-term, medium-term, and short-term view of the market in one snap — on one hand comparing the present and past prices with the Chinkou Span, and on the other hand, projecting the present key price levels into the future via the cloud component.
Essentially, the price interacts differently with the various lines. Thus, as a multi-component indicator, every component of the indicator generates a signal of its own. Here is how to interpret the signals from the various components.
Conversion Line / Base Line Cross
Just like in normal moving average crossover, a signal is generated when the Conversion Line crosses the Base Line.
In this case, the Conversion line behaves like a short-term moving average, while the Base Line behaves like a longer-term moving average.
When the Conversion line crosses above the Base Line, it is considered a bullish signal, and when the Conversion line crosses below the Base Line, it is seen as a bearish setup. See the chart below :
Chinkou Span
For the most part, when the Chinkou Span price is above the corresponding 26th past period’s price, the market is believed to be bullish, and when it is below the corresponding price, the market is assumed to be bearish.
In other words, if the Chinkou Span crosses the corresponding price upward, you may have a buying signal — especially if the price has crossed the cloud in that direction — and if the Chinkou Span crosses the price downward, there may be a selling signal.
When the Chinkou Span stays close to the price, the market may be in a consolidation. See the chart below :
The Cloud
The cloud serves 2 functions in the trading system :
-Shows the direction of the long-term trend
-Functions as support or resistance levels, depending on the direction of the trend
As regards the trend direction, you can decipher that from both the position of the price in relation to the cloud and the slope of the cloud.
When the price stays above the cloud, the market is in a bullish trend, and when the price stays below the cloud, the market is in a downtrend.
If the price is trading inside the cloud, the market is likely moving sideways, or the previous trend is in the process of changing direction.
Similarly, a descending cloud indicates a downtrend; a flat cloud shows a ranging market, while an ascending cloud indicates an uptrend.
Regarding the support and resistance functions, when the price is above the cloud, the various lines of the cloud act as support levels — with the top line as the first support level and the bottom line as the second support level.
On the flip side, when the price is below the cloud, the cloud becomes a resistance zone, with the bottom line acting as the first resistance level and the top line as the second one.
The price crossing from one side of the cloud to the other indicates a change in trend direction.
Where the price passes through the cloud may determine how soon the trend changes and how early a trade signal can appear —obviously, it is faster for the price to cross a twist than the full thickness of a large cloud. In the chart below, you can see a downtrend, a consolidation, and an uptrend.
Putting all together: creating a trading strategy with the Ichimoku Trading System
Now, you have learned the various components of the Ichimoku indicator and the nature of their signals, we can go ahead and consider how you can put everything together and develop an Ichimoku trading strategy that suits your style.
As a rule, the Ichimoku system only works in a trending market, so you can only have trend-friendly strategies with the system.
With that in mind, there are only 2 types of trades you can make with an Ichimoku strategy :
- Breakout trades
- Continuation trades
Breakout trades
These types of trades are used to capture the reversal of the trend — when the price reverses from a downtrend to an uptrend or vice versa.
Here are the steps to follow when buying into an upward trend reversal with the Ichimoku trading system:
-Check if the price has broken above the Ichimoku cloud: The price breaking above the cloud is one of the bullish signals you want to see before thinking of going long.
A break above the cloud shows a significant shift in market sentiment with a possible emergence of a new long-term trend in the upward direction.
-Check whether the Conversion line has crossed above the Base Line: The second bullish signal to look for is the Conversion line crossing above the Base Line.
This shows an upward momentum in the short-term trend, which supports a long position.
-Check whether the Chinkou Span is above the price: The third condition to consider before going long is the position of the Lagging Span with reference to the price.
If the Lagging Span has risen above the price when the above two conditions have been met, a buy signal is confirmed.
-Buy with the next candlestick after all the 3 conditions are met: With all the 3 conditions met, it is time to buy.
You can either buy with a market order at the opening of the next candlestick or place a buy stop order above the high of the breakout candlestick, whichever suits the market situation.
-Place a stop loss below the cloud: While you may keep your stop loss below the breakout candlestick, it is safer to keep it some pips below the cloud if it is lower than the former.
-Consider where to take profit: You may put a profit target at a suitable resistance level where you can get at least a 2x reward for your risk.
Alternatively, you can use the reverse Conversion line / Base Line crossover — the Conversion line crossing below the Base Line — as an indication to get out of the trade.
In the Silver chart below, the price broke above the cloud. Before then, the Chinkou Span has crossed above the price, and the Conversion line has crossed above the Base Line. Notice the position of the stop loss and the possible time to exit the trade.
When selling into a downward trend reversal, follow these steps :
-Check if the price has broken below the Ichimoku cloud: One of the bearish signals to look for is the price breaking below the cloud.
A downward breakout of the cloud indicates a deep shift in market sentiment with a possible emergence of a new long-term trend in the downward direction.
-Check whether the Conversion line has crossed below the Base Line: The second bearish condition is the Conversion line crossing below the Base Line. It shows that the short-term trend is downward and is gaining momentum.
-Check whether the Chinkou Span is below the price: The third condition to consider is the position of the Chinkou Span with reference to the price. If the Chinkou Span is below the price, then the third condition is met.
-Sell with the next candlestick open after all the 3 conditions are met: When all the 3 conditions are met, you can go short with a market order at the opening of the next candlestick, or you place a sell stop order below the breakout candlestick’s low, whichever suits the market situation
-Place a stop loss above the cloud: You may keep your stop loss above the high of the breakout candlestick, but it is safer to keep it some pips above the cloud if it is higher than the former.
-Know where to take profit: You can take profit when the Conversion Line crosses above the Base Line.
Alternatively, you may put a profit target at a suitable support level where you can get at least a 2x reward for your risk.
The FTSE MIB Index chart below shows how the price broke below the cloud. By then, the Chinkou Span was already below the price, and the Conversion line has crossed below the Base Line. Note the position of the stop loss.
Continuation trades
Since the cloud can act as support or resistance levels depending on the type of trend, trading a price bounce at the cloud can be a profitable strategy, just like other pullback strategies.
Here is how to play this in an uptrend :
-Confirm that the longer-term trend is up — the price is staying above a gradually rising cloud
-Wait for the price to pull back to the upper boundary of the cloud (the SSA), which is the first support level
-Look for bullish candlestick patterns (bullish pin bar, engulfing bar or inside bar) or a bullish divergence in the RSI
-Go long when the price starts rising again
-Place a stop loss some pips below the swing low or the SSB line, whichever is lower
-Put a profit target at a suitable resistance level
In the Dow 30 Index chart below, the price pulled back to the cloud. An inside bar formed right inside the cloud, and the price started rising again.
In a down-trending market, here are the steps to follow :
-Confirm that the longer-term trend is downward — the price is staying below a downward-sloping cloud
-Wait for the price to pull back to the SSA (the lower boundary of the cloud), which is the first resistance level
-Look for bearish reversal signals, such as bearish candlestick patterns (bearish pin bar, engulfing bar or inside bar) or a bearish divergence in the RSI
-Go short when the price starts dropping following a bearish signal
-Place a stop loss a few pips above the SSB line or the swing high, whichever is higher
-Put a profit target at a suitable support level
This is an H3 chart of the Dow 30 Index showing the Covid19-induced bear market. The price rallied to the Ichimoku cloud and ended with an inside bar. Subsequently, the decline resumed.
Final words
Ichimoku Kinko Hyo is an all-encompassing trading indicator that shows the direction of the prevailing trend; gauges the strength and momentum of a trend; provides reliable support and resistance levels; and offers reliable trade signals.
So, you can develop a full trading system with this one indicator. We advise that you study this guide well and develop an Ichimoku trading strategy that suits your trading style.