If there was ever one indicator that was both incredibly helpful and horribly overwhelming all at the same time, the Ichimoku Cloud woud be it. At first glance, this thing looks like a 3 year old just drew squiggles on your screen. If you take the time to understand what it really is however, it may help you get to a whole different level in trading. Or it may inspire you to color more with your kids, you just have to do what works best for you.
Let’s start out by seeing what the cloud looks like in it’s raw form and then we’ll dissect this piece by piece.
This is overstock, inc. It’s getting out of the online space and into the bitcoin space, notice how much the market appreciated this move. Now that we’ve got our example, let’s dig in.
There are two important rules to learn before we break this thing down.
Rule #1. There are only 5 parts to the cloud.
Before you get insanely overwhelmed, just realize that no matter how many squiggles it looks like there really are, it’s only five pieces. Most charting packages allow indicators or parts of the indicator to go clear as well. There are many traders who prefer to know which side of the cloud they are on, but take it no further than that. Remember, it’s all about you. There’s no golden rule that requires you must use all parts, just keep that in mind going forward.
Rule #2. All of these lines are still based off price.
They are shifted forwards and backwards as well as used real time so they may seem much more complicated than normal, but that is nothing more than simple computing code. When you realize the math isn’t that much off from a simple moving average, you start to understand this isn’t as insane as you though it was.
We will attempt to explain each part in detail and also give a shorter version to bring it home. There are five indicators built into one in this ichimoku cloud:
- Senkou Span A
- Senkou Span B
Tenkan (Yellow Line). The Tenkan Sen Line (Called Tenkan for short) is a moving average which prints the middle value between the highest and lowest points over the last 9 bars.
Layman’s terms: It plots the middle ground over the last 9 bars.
Kijun (Purple Line). The Kijun Sen Line (called Kijun for short) uses the same middle value plotting as the tenkan line. The difference being it uses a 26 period range instead of a 9 period range.
Layman’s terms: It plots the same middle ground over a longer timeline, 26 bars instead of 9.
Chikou (Light Blue). Chikou Span (called Chikou for short) plots the current price, shifted 26 periods to the left.
Layman’s terms: It plots the current price shifted left, helps to see if trending or chop.
Senkou Span A (White Line). The Senkou Span A (called the cloud when combined when Senkou Span B) is the most complicated part of this formula. We will break it down together. The span A line is found by adding the Tenkan Line + Kijun Line together, dividing by 2, and plotting this point 26 periods to the right on the chart.
Layman’s terms: It takes the average of the 2 previous averages and then plots it into the future.
Senkou Span B (Orange Line). Senkou Span B (called the cloud when combined when Senkou Span A) plots the middle value of the high’s and low’s just like the Kijun and Tenkan lines. The difference being this line uses a 52 price period (the longest of the three).
Layman’s terms: It’s a longer version of the kijun line, 52 bars instead of 26.
Now that you know what it is, what’s your first though? Have you noticed how similar it is to MACD in the candle length’s usage? What about how it really just prints the same results in multiple ways? It’s not all that complicated now, is it?
So if you know what it is, what should you do with it?
What To Do With It
Before we go looking at ways to use this in our trading, let’s cover some basics you really want to consider sticking with, if you decide to use this indicator. Nothing works every time and you’ve got to test this stuff to see if it works for you at all, but here’s some tried and tested thoughts on this indicator from my own experience.
- If adding this indicator to your charts, at least in tradestation, you must add 26 bars to the right of spacing or the indicator will not work properly.
- If trying to trend trade, stay away from setups that are too far into the cloud or on the wrong side of the cloud.
- If trading a breakout, the Chikou line (lagging 26 range line) should be above the cloud and preferably above all previous price action. Remember, if this line is shifted into the past by 26 bars, and you are trading a breakout, shouldn’t current price action be above previous price action?
- The cloud is based off highs/lows not off closing price action. A rising tenkan/kijun line combination shows the range is bullish and moving. Choppy range bound stocks cannot create convincing clouds and as such help predict when to get in vs passing on chop.
- As the cloud is shifted forward by 26 periods, the cloud in the future should be in your direction as well whenever possible.
Let’s take a look at our example again and see if we can’t find out how to put these rules into practice.
The arrows are what we’re going to look at. They are color coded for ease of reading.
Price makes it’s first breakout attempt on the daily at the orange arrows. Assume we are using the 2nd arrow as our entry point, the 1st arrow is to show where the Chikou line is (Rule 3 above).
When price makes it’s first breakout attempt, the chikou line is above the cloud but not above previous price. The breakout fails.
The next attempt at the yellow arrow’s gets price above the cloud (2nd arrow) but the chikou line this time is above price action but below the cloud (1st arrow) and the breakout fails.
The green arrows at the 3rd breakout attempt give way to a monster. Notice when price breaks out at the 2nd green arrow, the chikou line (1st green arrow) is above previous price action and the cloud.
Looking forward 26 bars notice the green box showing the cloud is bullish and staying bullish.
This was the only spot that all 4 rules were followed and as a result this trade produced substantial results.
Notice also that on the deep pullback where OSTK lost almost 30% in 2 weeks, the cloud never crossed over, not even in the future. This showed that shorts are not the right setup at this time. This is only one example and of course anything can work one time, but this should help show the power of this indicator for trading trends. Whether or not you take the time to study and test it is entirely up to you.
A Word of Warning
The Ichimoku Cloud is an excellent indicator as a one look type play. Plenty of traders use moving averages, MACD, crossovers, etc. to gauge price based on previous closes. Few indicators use range as well as the cloud does, and by ignoring closing action and focusing on both sides of the extremes, you can gauge potential breakouts in an entirely different way.
Before you start tweaking this or looking for ways to make it even better, however, remember it was developed by a Japanese journalist in the 1930s and was not released to the public until the 1960s. This doesn’t mean it can’t be improved, but if the creator spent 30 years developing and tweaking it, don’t think you’ll top him in a week. Unless you can undeniably quantify WHY you are adjusting the settings, don’t. This goes back to the rabbit trail we talked about in indicators 101. When you constantly look for the little tweaks, you can get caught in an infinite loop that never pays out.
There are specific strategies you can use with this indicator, but we will save those for another post. For now, after reading this, we hope you’ve gotten a much stronger understanding of the ichimoku cloud and a better idea of how to gauge a trend.