What is the Ichimoku Cloud? 一目均衡表

Ichimoku Cloud

Ichimoku cloud is a type of technical analysis indicator that is highly popular and favored among Japanese traders. I always believed in knowing the basics of technical analysis as it gives you a lot of price insights and market sentiment that fundamental analysis is unable to provide. The problem with technical analysis is that there are dozens of indicators, different markets have different patterns, some work and some don’t.

Often times, we hop around learning all sorts of indicators and the end result is we learnt nothing and hardly any of them proved to be effective consistently. Then we start to doubt the reliability of technical analysis, rationalizing that it is a lagging metric which does not tell you anything about price action in the future. And the last statement is true because nobody can predict Mr. Market’s mood tomorrow. Technical analysis only provides you a probability but not a guarantee. Alright, so what’s Ichimoku Cloud and why Ichimoku?

The first reason I love Ichimoku Cloud is because it’s a stand-alone system. Meaning you only need to use the Ichimoku Cloud indicator and there is no need for you to add in all other kinds of indicators, lines and arrows that messes up your whole chart. (even though you can) It’s a great tool to use for beginners! If you have zero knowledge in technical analysis but want to get started, all you need to learn is this one indicator, Ichimoku Cloud. It’s better to master one indicator and use it well THAN to learn 10 indicators but unsure of how to use them individually or concurrently.

Secondly, it is clean, simple and effective. This indicator is not complex to understand, there are no statistical formulas and anyone can learn Ichimoku cloud charting. After you have finished reading this blog series. you would definitely gain a basic understanding on Ichimoku Cloud and learn how to apply them effectively.

Thirdly, Ichimoku Cloud is BOTH a lagging indicator and leading indicator. Most indicators are either lagging indicator which doesn’t tell you anything about the future OR leading indicator which doesn’t tell you anything about the past. Examples of lagging indicator is moving average, where it calculates the average price of the past n periods. The data is computed BASED UPON past data and it gives no signal or whatsoever on what is going to happen next.

Leading indicator on the other hand aims to foretell what would investors do next. Examples of leading indicator are volume oscillators such as Relative Strength Index (RSI). RSI is a momentum indicator that measures whether an asset is overbought or oversold. If an asset is overly-sold, then we can expect investors to jump in at discounted prices in the next few periods. Vice versa, if an asset is overly-bought, we can foresee what investors are going to do next. They are going to start selling off their overvalued assets and lock-in profits before getting back in when prices retrace back to its mean. This is what’s meant by leading indicator, you are predicting what price action is going to happen next. Ichimoku Cloud combines the best of both worlds (lagging + leading) as we will see later.

Fourthly, Ichimoku Cloud contains all the price’s action and behavior into just one indicator. You don’t have to plot a momentum indicator to measure momentum, volume indicator to measure volume etc. Ichimoku Cloud provides insight into short-term/medium-term/long-term market bias, support & resistance levels/zones, momentum, volatility and direction of trend.

Lastly, and this is what I LOVE most about Ichimoku Cloud is it saves a lot of time and analysis. All you need is just put in the clouds and in a single GLANCE, one is able to extract all the necessary information in a second. ALL in just one GLANCE. Let’s trace back to why “One Glance” and who invented Ichimoku Cloud.

Origin of Ichimoku Cloud

The Ichimoku cloud indicator was developed by a Japanese journalist named Ichimoku Sanjin or Kinkō Hyō (一目均衡表). His name can be loosely translated as (“A man standing on top of a mountain” or “Glance from the top of a mountain”). Ichimoku started analyzing chart patterns from 1940 and he spent 30 years experimenting, doing back-testing, trials, perfecting and refining his system before publishing his book in 1968. Back then there were no computers and crunching numbers were done manually by his students. I would be fairly assured on the soundness of the Ichimoku system given that he dedicated a-third of his life doing this.

The meaning of his name can be broken down as such. The first character, 一 (pronounced as Yichi), means one or once. The second character, 目 (pronounced as Moku), is the eye, glance or sight. The third character, 均 (pronounced as Kin), means equal, even or uniform. The fourth character, 衡 (pronounced as Ko), is balance or equilibrium. And lastly, the fifth character, 表 (pronounced as Hyo), means foot like how market leave foot prints. If you piece everything up together, Yichimoku Kinko Hyo directly translated is “one glance equal equilibrium market”.

Ichimoku cloud is able to give you a clear sense of market perspective and clarity from just one look on top of the mountain. Just as in life, you have a clearer overview of what’s happening on the top as compared to when you are at the bottom.

Characteristics of Ichimoku Cloud

The standard time-frame for Ichimoku is originally used on a daily scale. So this technique is suitable for mid-to long-term investors. But now traders have used in on the hourly, minutes or weekly time frame. The most IMPORTANT thing to keep in mind is that the effectiveness of Ichimoku cloud is more applicable for TRENDING market (uptrend or downtrend). If it’s a ranging/consolidation market, it’s best to stay out of any trade. Don’t bother analyzing chart patterns using Ichimoku cloud. It would give you lot’s of false signals, confusions and the outcome would be disastrous.

The main difference between Ichimoku and traditional western chart indicators is that Ichimoku doesn’t take the closing price, instead the mid-point is taken. Remember his middle name character 均衡 represents equilibrium and balance? The philosophy of Ichimoku is always about the center, central, equilibrium mid point. For example, a 10-day moving average takes the average of the past 10 days closing price but Ichimoku would take the highest price point of the past 10 days + lowest price of past 10 days divided by 2 to give us the mid-point price. Alright, let’s get into the specifics.

Components of the Ichimoku Cloud

Ichimoku Cloud on DJIA’s weekly chart

The Ichimoku Cloud looks really complicated on first glance, but it’s not that complex actually. Basically, there are 6 components in an Ichimoku system: The Tenkan-Sen, Kijun-Sen, Chiko Span, Senkou Span A, Senkou Span B and Kumo Cloud.

a) Tenkan-Sen

DJIA
Tenkan-Sen line drawn on DJIA’s weekly chart

Tenkan-Sen (red line), also known as the “Conversion Line” is a 9-day moving average. But instead of the traditional moving average where the average price is calculated by taking the mean of the past 9 periods, Tenkan-Sen is calculated by taking the (HIGHEST price in the past 9 days + LOWEST price in the past 9 days) divided by 2. This is the short-term bias indicator and its the most sensitive to price movement. As you would observed, Tenkan-Sen sticks very closely to prices and it can act as the first line of support/resistance for a bounce during an uptrend/downtrend.

b) Kijun-Sen

DJIA
Kijun-Sen line drawn on DJIA’s weekly chart

Kijun-Sen (blue line), also known as the “Base Line” is a 26-day moving average. Similarly to the Tenkan-Sen, it is calculated by taking the (HIGHEST price in the past 26 days + LOWEST price in the past 26 days) divided by 2. This is the medium-term bias indicator and it reacts slower to changes in price movement as compared to the Tenkan-Sen. Kijun-Sen also acts as a support/resistance and is the second line of defense after the Tenkan-sen.

Why 6 days and 26 days is used for Tenkan-Sen and Kijun-Sen respectively? The reason is because in the past, Japanese used to work 6 days a week or around 26 days a month. So you can think of Tenkan-Sen as finding out what is the mid point price of the previous week and Kijun-Sen as finding out what is the mid-point price of the previous month. However, after several trial-and-errors, back-testing and refining, 9 days was determined to yield the best result in conjunction with 26 days.

You notice that for the past 3-4 years, every time price hits the Tenkan-Sen line or Kijun-Sen line it bounces off upwards until recently both line of defense are broken and disrespected. (*Warning: Red flag is up)

c) Senkou Span A

This is the first line of cloud and is the midpoint between the Tenkan-Sen and Kiju-Sen. To find Senkou Span A, we simply add Tenkan-Sen and Kijun-Sen divided by 2. The mid-point of the price is then plotted 26 periods AHEAD from its current trading date. Senkou Span A is the third line of defense and it acts as a support/resistance AFTER the Kijun-Sen.

d) Senkou Span B

This is the second line of the cloud and its calculated by finding the (HIGHEST price within the last 52-period + the LOWEST price within the last 52-period) divided by 2. The midpoint price is then plotted 26 periods AHEAD from the its current trading date. This is the long-term bias indicator as the time period is the LONGEST. Senkou Span B usually stays flat because the market has to make higher high or lower low for Senkou span B to change.

Imagine we are using a weekly time-frame and we want to calculate the mid-point price of the Senkou Span B. If price fluctuates below its 52-week high and above its 52-week low, then both numerator figures remains unchanged and the mid-point price stays the same. Hence, Senkou Span B is often times relatively flat and it acts as the LAST line of defense after Tenkan-Sen, Kijun-Sen and Senkou Span A. But if market is making HIGHER highs or LOWER lows, then Senkou Span B would be either sloping upwards or downwards respectively. Support/resistance at Senkou Span B is also the strongest fortress as its the long-term bias indicator.

Another way to look at Senkou Span B is that it can be akin to a 50% retracement level as it is the mid-point of the last 52 period. Since it is the mid-point between its 52-period high and low, you can think of it as “prices are 50% below its 52-period high.”

e) Kumo Cloud

DJIA
Kumo Cloud acting as support/resistance on DJIA’s weekly chart

Both Senkou Span A and Senkou Span B forms what is commonly known as the “kumo cloud” or “cloud”. It is the shaded region between Senkou Span A and B. As you would have noticed, Senkou Span A and Senkou Span B is a support level and price bounces off when it hits the clouds.

If Senkou Span A is ABOVE Senkou Span B, the color of the cloud would be green and its a bullish trend. Similarly, if Senkou Span A is BELOW Senkou Span B, the color of the cloud would be red and its a bearish trend. Why is that so? The reason is because if Senkou Span A is above Senkou Span B, it means prices are ABOVE the mid-point price of the year (assuming weekly time-frame). Vice versa, if Senkou Span A is below B, it means prices are BELOW the mid-point price of the year.

Kumo Cloud serves as a LEADING indicator because it provides a clue on price action of the market 26 periods from today, BASED UPON current Medium-term (Senkou Span A) price action & long-term (Senkou Span B) price action. If you are taking a long position, the clouds you see ahead 26 periods from now should be green and vice versa, if you are taking a short position, the clouds you see ahead 26 periods should be red.

f) Chiko Span

DJIA
Chiko-span line on DJIA’s weekly chart

Chiko-span also known as the “lagging span” and it involves no calculations. It’s simply just the current price of today PUSHED back 26 periods before that’s all. The way to interpret the Chiko-span is to ask if the Chiko-span is ABOVE or Below price 26 periods before. If Chiko-span is above price, it means my current price today is HIGHER than that of 26 periods ago and vice versa if Chiko-span is below price, it means my current price today is LOWER than that of 26 periods ago.

Summary

To sum up, there are 6 components in the Ichimoku Cloud indicator. Tenkan-Sen is simply the highest price + lowest price of the past 9 periods divided by 2. Kijun-Sen is the highest price + lowest price of the past 26 periods divided by 2. Senkou Span A is Tenkan-Sen + Kijun-Sen divided by 2. Senkou Span B is the highest price + lowest price of the past 52 periods divided by 2 and Chikou Span is today’s price plotted 26 periods back. Both Senkou Span A and Senkou Span B forms the Kumo cloud.

There are basically 4 layers of support/resistance or 4 lines of defense. First is the Tenkan-Sen, followed by Kijun-Sen, then price hits the Kumo cloud Senkou Span A followed by Senkou Span B. Tenkan-Sen is the short-term bias indicator and support/resistance on the Tenkan-Sen is the weakest. Senkou Span B is the long-term bias indicator and support/resistance on the Last line of defense is the strongest.

We have come to an end on part 1 of the Ichimoku Cloud series. We have covered on who invented Ichimoku Cloud, why Ichimoku Cloud? What are the components of Ichimoku Cloud, characteristics of Ichimoku Cloud etc. Do keep a lookout on part 2 of this series where I will talk about Ichimoku Cloud strategies, how to interpret them and how to use them effectively!

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