The Ichimoku cloud or Kinko Hyo is a Japanese technical indicator created by Japanese journalist Goichi Hosoda in 1930. But it was first published in 1969 after years of research. This indicator can be defined as an all-in-one technical indicator.
What is the Ichimoku Cloud?
A trader has to look toward multiple technical indicators to find different signals. But this indicator is equipped with such versatility that it can give traders multiple signals.
With the help of five different average lines and a cloud formation, the Ichimoku cloud indicator gives indications of trend direction, support and resistance and gives buy and sell signals. We, therefore, find the name all-in-one indicator given to the Ichimoku cloud indicator very apt.
The Ichimoku cloud indicator suits the traders who do intraday trading. The chart below shows the 15-minute chart of Nifty. The signals are very prominent here. We will discuss it later about the signals.
Ichimoku Cloud Formula
The Ichimoku cloud formula consists of five different lines. They all are different averages represented by lines. These are as follows.
The Conversion line (Tenkan Sen) = (9 period high + 9 period low) / 2
Base line (Kijun Sen) = (26 period high + 26 period low) / 2
Leading span A (Senkou span A) = (Conversion line + Base line) / 2
Leading span B (Senkou span B) = (52 period high + 52 period low) / 2
Lagging span (Chikou span) = 26 periods close plotted in the past.
The names given in the brackets are their corresponding Japanese names. Here, for the sake of this article, we will use these in their respective English names only.
How is Ichimoku Cloud Calculated?
As seen in the formula above, we need to calculate the Ichimoku cloud indicator in sequential steps. We first need to calculate the Base line and Conversion line.
It must be mentioned that the Ichimoku cloud calculation considers the highest of the highs and the lowest of the lows for a specific period.
Some charting platforms have Ichimoku cloud automatically plotted in the chart for the benefit of their customers. Others may like to calculate it manually. Let’s see how to do that.
First, calculate the Conversion line and the Base line by taking the averages as shown in the formula.
Secondly, check previous calculations and using them find out Leading span A. Once this is complete, the data project of 26 periods can be seen.
Now we calculate the Leading span B. A 26-period data in the future must also be projected.
Now we need to calculate the lagging span. Calculate the past 26-period closing price and plot the line on the chart.
After the lagging line is plotted, we can see the differences between the two lines which creates the Ichimoku cloud.
When the leading indicator goes above the lagging indicator, it should be green in colour and red if the opposite occurs. Thus, the cloud turns green when the condition is favourable for a buyer and turns red if it is a seller’s market.
The six steps mentioned above create a single data point. If the steps mentioned above are repeated at every different data point and joined together, the five lines and the cloud will be created.
Five Lines of Ichimoku Cloud Indicator
Given below is a price chart where all the five lines are properly mentioned. We will delve into details of the structure of these five lines.
The Tenkan Sen (Conversion Line)
The Conversion line is also known as Tenkan Sen. As we have seen in the formula, the Conversion line (Tenkan Sen) = (9 periods high + 9 periods low) / 2.
It is the average of the previous 9 periods calculated by taking the highest of highs and lowest of lows and dividing the number by 2.
It is not the same as taking the moving average of the previous 9 periods. Taking an average of the highs and lows instead of taking only the closing prices proves to be more effective, as per their philosophy.
The concept of price equilibrium by using the Ichimoku indicator was introduced when this method of averaging was applied.
This line is a leading indicator and reacts readily with price changes. But if we compare it with the simple moving average SMA of the same period, we will see the Conversion line or the Tenkan Sen flattens down instead of reacting to every price change. When whipsaw movements occur in SMA, the Tenkan Sen flattens down showing no trade zone.
The Conversion line or the Tenkan Sen acts as a trend indicator. When the price goes above the Tenkan Sen, it is in an uptrend and the Tenkan Sen acts as the support line.
When the price goes below the Tenkan Sen, it is considered that the price is in a downtrend. At those times, this line acted as resistance.
To measure the price momentum, the angle of price slope with the horizontal line is used. During ascent, a steeper angle shows greater price momentum. Similarly, during descent, a steeper angle of descent indicates a greater price momentum.
The Kijun Sen (Base Line)
The Kijun Sen or the Base line is somewhat similar to Tenkan Sen. The formula for Base line or Kijun Sen is Base line (Kijun Sen) = (26 periods high + 26 periods low) / 2.
So, we are taking the highest highs and the lowest lows of the previous periods instead of 9 periods. Hence, the Kijun Sen reacts to price movement more slowly than the Tenkan Sen but it is more stable.
As there is less reaction to price movements, it is considered to be more accurate than the Tenkan Sen.
Therefore, one look at the Kijun Sen will be enough to know the trend seeing which way the line is moving.
When the price falls below the lowest lows or rises above the highest highs, the Kijun Sen reacts accordingly. The Kijun Sen will move up when the highs are broken and show a bullish trend.
Similarly, during the bearish trend, the Kijun Sen will go downwards when the price goes below the lowest lows and show a downtrend.
Similar to Tenkan Sen, the Kijun Sen shows immediate price resistance or support.
When the price moves above the Kijun Sen and goes above the cloud, it is time to buy.
And when the price goes below the Kijun Sen convincingly and also goes below the cloud, it is time to sell.
During the whole course of price movement. the price goes below or above the Kijun Sen more often than not. Therefore, many traders use the Kijun Sen as the reference line for trading signals.
The Chikou Span (Lagging Span)
The Chikou span is a lagging indicator which follows the price movement. The formula for the Chikou span is Lagging span (Chikou span) = 26 periods close plotted in the past.
It means instead of plotting the current 26 periods’ closing price, the Chikou span plots the closing prices of 26 periods ago.
The idea behind this is to compare the current price with the past 26 periods’ closing price instantly.
Thus, the current trend is readily available.
Hence, if the current price goes above the past price, it is bullish and vice versa.
The Chikou span also provides support and resistance levels as seen in the chart below.
The Senkou Span A (Leading Span A)
This is another line which is a leading indicator.
The formula for Senkou span is Leading span A (Senkou span A) = (Conversion line + Base line) / 2
Hence this is an average of the Conversion line and the Base line.
It is plotted 26 periods ahead of the current price.
The Senkou span A is calculated by taking the last 26 periods because the Tenkan Sen is calculated by using the last 9 periods and the Kijun Sen is calculated by using the last 26 periods.
This line is slanting along with the price curve and does not remain flat.
The Sekou span A forms the first part of the Kumo (the cloud).
If the prices are above this line, then it acts as the support line. But if the price is below the Senkou span A, then it acts as the resistance line.
The Senkou Span B (Leading Span B)
The Senkou span B is calculated by using the midpoint of the last 52 periods. The formula for the Senkou span B is Leading span B (Senkou span B) = (52 periods high + 52 periods low) / 2.
Because of the long periods taken to calculate it, the line remains flat most of the time.
If the price is above Senkou span B, the price is bullish and this line acts as the longer time support comparatively. On the contrary, if the price goes below this line, this line may become the resistance.
The Senkou span B forms the other half of the cloud.
The Cloud (Kumo)
The cloud is also known as the Kumo. This is a region formed by Senkou span A and Senkou span B. When the Senkou span A rises above the Senkou span B, it turns out to be a bullish Kumo or a bullish cloud. When the Senkou span B goes above the Senkou span A, kt is a bearish cloud. When the price goes above the bullish cloud, the price is in a bullish trend.
Similarly, when the price falls below the bearish cloud, the price is in a downtrend.
If the price moves within the cloud, it is a no-trade period.
When the Ichimoku cloud indicator forms on a chart, the cloud and the lines together tell us the same story.
How to Use the Ichimoku Cloud Indicator?
The cloud and its edges define the support and resistance and define the future potential support and resistance lines.
With the change of price, the shape and size of the cloud change conveying different meanings.
When the price change is large, the cloud becomes thicker. A Thicker cloud creates stronger support and resistance levels.
When the cloud height increases, it signals higher volatility.
When the cloud formation is thin and flattish, it signifies that the price movement is weak and any time the price can pierce the support/ resistance levels. This creates more whipsaw movements. This environment is not ideally suited for trading.
We have already mentioned how we can find the trends. When the current cloud is green the trend is positive.
In the case of red cloud formation, the price trend is negative.
When the cloud is green, the cloud is thick and the cloud ascent is steeply inclined, it is a strong bullish trend.
Contrarily, if a thick cloud is red, thick and declining steeply, it is a strong bearish trend.
At times, the cloud forms just behind the prices. It is known as Kumo Shadows. The Kumo Shadows are helpful for a trader to find immediate support/ resistance. These also help the trader to create trailing stop losses.
Support and Resistance Levels
We have already discussed how the cloud acts to provide support and resistance levels.
When the Senkou span A crosses the Senkou span B, it is a bullish crossover and the stock is trending up.
When Senkou span A falls below the Senkou span B, it is a bearish crossover indication that the stock has turned bearish.
Ichimoku cloud Trading Strategy
For bullish trade, the following criteria must be fulfilled.
- The price should be above Tenkan Sen or the Conversion line.
- The Tenkan Sen should be above Kijun Sen or the Base line.
- Both Tenkan Sen and Kijun Sen should be moving upwards.
- The Kijun Sen must not be too far away from the price.
- The future Kumo should be bullish.
- The price should be above Kumo (cloud)
After all the criteria mentioned above are met, a trader may initiate a buy position. But we must be cautious if the price moves far away from Kijun Sen creating a big gap. Because, if the gap is big, Kijun will attract price towards it and there will be a fall.
We can see the same is happening at points B and D. After B the price took support in Kijun, but after D the price pierced Kijun and the downtrend started.
For bearish trade, the following criteria must be fulfilled.
- The price should be below Tenkan Sen or the Conversion line.
- The Tenkan Sen should be below Kijun Sen or the Base line.
- Both Tenkan Sen and Kijun Sen should be moving downwards.
- The Kijun Sen must not be too far away from the price.
- The future Kumo should be bearish.
- The price should be below Kumo (cloud)
After all the criteria mentioned above are met, a trader may initiate a short position. But we must be cautious if the price moves far away from Kijun Sen creating a big gap. Because, if the gap is big, Kijun will attract price towards it and price will go up.
Limitations of Using the Ichimoku Cloud Indicator
There are a few limitations of the Ichimoku cloud indicator. We should look into them.
This indicator looks complicated. There are too many lines and signals there. Hence it will be very hard for newbies to have a grip on this indicator within a short period of time.
The Ichimoku Cloud indicator is based on historical data points. But it plots two data points in the future.
If the price remains above or below the cloud for longer periods, the cloud becomes irrelevant and remains for a longer period due to future data point projection.
Overall, this indicator is very efficient and gives multiple signals to the traders. It produces clear buy and sell signals.
Once the lines are understood, the signals become very easily manageable.
It must be noted that the Chikou span (lagging span) should not get obstructed by the cloud. Chikou span must be free to move upwards or downwards for a bullish or bearish trend. The Chikou span represents the market sentiment in a nutshell.