Ichimoku Clouds Explained
The Ichimoku Cloud is a method for technical analysis that combines multiple indicators in a single chart. It is used on candlestick charts as a trading tool that provides insights about potential support and resistance price zones. It is also used as a forecasting tool, and many traders employ it when trying to determine future trends direction and market momentum.
The Ichimoku Cloud was conceptualized in the late 1930s by a Japanese journalist named Goichi Hosada. However, his innovative trading strategy was only published in 1969, after decades of studies and technical improvements. Hosada called it Ichimoku Kinko Hyo, which translates from Japanese as “equilibrium chart at a glance.”
How does it work?
The Ichimoku Cloud system displays data based on both leading and lagging indicators, and the chart is made up of five lines:
Conversion Line (Tenkan-sen): 9-period moving average.
Base Line (Kijun-sen): 26-period moving average.
Leading Span A (Senkou Span A): the moving average of the Conversion and Base Lines projected 26 periods in the future.
Leading Span B (Senkou Span B): 52-period moving average projected 26 periods in the future.
Lagging Span (Chikou Span): the closing price of the current period projected 26 periods in the past.
The space between the Leading Span A (3) and Leading Span B (4) is what produces the cloud (Kumo), which is likely the most notable element of the Ichimoku system. The two lines are projected 26 periods in the future to provide forecasting insights and, as such, are considered leading indicators. The Chikou Span (5), on the other hand, is a lagging indicator projected 26 periods in the past.
By default, the clouds are displayed in either green or red - to make the reading easier. A green cloud is created when the Leading Span A (green cloud line) is higher than Leading Span B (red cloud line). Naturally, a red cloud results from the opposite situation.
It is worth noting that - unlike other methods - the moving averages used by the Ichimoku strategy are not based on the closing prices of the candles. Instead, the averages are calculated based on the high and low points recorded within a given period (high-low average).
For instance, the standard equation for a 9-day Conversion Line is:
Conversion Line = (9d high + 9d low) / 2
After over three decades of research and testing, Goichi Hosada concluded that the (9, 26, 52) settings had the best results. Back then, the Japanese business schedule included Saturdays, so the number 9 represents a week and a half (6 + 3 days). The numbers 26 and 52 represent one and two months, respectively.
While these settings are still preferred in most trading contexts, chartists are always able to adjust them to fit different strategies. In cryptocurrency markets, for example, many traders adjust the Ichimoku settings to reflect the 24/7 markets - often changing from (9, 26, 52) to (10, 30, 60). Some go even further and adjust the settings to (20, 60, 120) as a way to reduce false signals.
Still, there is an ongoing debate about how efficient modifying the settings may be. While some argue it makes sense to adjust them, others claim that abandoning the standard settings would disrupt the balance of the system and produce lots of invalid signals.
Analyzing the chart
Ichimoku trading signals
Due to its multiple elements, the Ichimoku Cloud produces different types of signals. We may divide them into momentum and trend-following signals.
Momentum signals: are generated according to the relationship between the market price, Base Line, and Conversion Line. Bullish momentum signals are produced when either or both the Conversion Line and the market price move above the Base Line. Bearish momentum signals are generated when either or both Conversion Line and market price move below the Base Line. The crossing between the Conversion Line (Tenkan-sen) and the Base Line (Kijun-sen) is often referred to as a TK cross.
Trend-following signals: are generated according to the color of the cloud and to the position of the market price in relation to the cloud. As mentioned, the cloud color reflects the difference between the Leading Spans A and B.
Simply put, when prices are consistently above the clouds, there is a higher probability that the asset is in an upward trend. In contrast, prices moving below the clouds may be interpreted as a bearish sign, indicating a downtrend. Save a few exceptions, the trend may be considered flat or neutral when prices are doing sideway movements inside the cloud.
The Lagging Span (Chikou Span) is another element that can help traders spot and confirm potential trend reversals. It provides insights into the strength of price action, possibly confirming a bullish trend when moving above market prices, or a bearish trend when below. Normally, the Lagging Span is used in conjunction with the other components of the Ichimoku Cloud, and not on its own.
Market price moving above (bullish) or below (bearish) the Base Line.
TK cross: Conversion Line moving above (bullish) or below (bearish) the Base Line.
Market price moving above (bullish) or below (bearish) the cloud.
Cloud color changes from red to green (bullish) or from green to red (bearish).
Lagging Span above (bullish) or below (bearish) market prices.
Support and resistance levels
The Ichimoku chart can also be used to identify support and resistance zones. Typically, the Leading Span A (green cloud line) acts as a support line during uptrends and as a resistance line during downtrends. In both cases, the candlesticks tend to move closer to the Leading Span A, but if the price moves into the cloud, the Leading Span B may also act as a support/resistance line. What’s more, the fact that both Leading Spans are projected 26 periods in the future allows traders to anticipate potential coming support and resistance zones.
The strength of the signals generated by the Ichimoku Cloud depends heavily on whether they fall in line with the broader trend. A signal that is part of a larger, clearly defined trend will always be stronger than one that crops up briefly in opposition to the prevailing trend.
In other terms, a bullish signal may be misleading if not accompanied by a bullish trend. So, whenever a signal is generated, it is important to acknowledge the color and position of the cloud. The trading volume is also something to be considered.
Mind that using Ichimoku with shorter timeframes (intraday charts) tends to generate a lot of noise and false signals. Generally speaking, longer timeframes (daily, weekly, monthly charts) will produce more reliable momentum and trend-following signals.
Goichi Hosada dedicated over 30 years of his life to create and refine the Ichimoku system, which is now employed by millions of traders worldwide. As a versatile charting method, Ichimoku Clouds are used to identify both market trends and momentum. Also, the Leading Spans make it easier for chartists to anticipate potential levels of support and resistance that are yet to be tested.
Although the charts may look too busy and quite complex at first, they don’t rely on subjective human input like other methods of technical analysis (e.g., drawing trend lines). And despite the continuous debate about Ichimoku settings, the strategy is relatively easy to use.
As with any indicator, though, it should be used in conjunction with other techniques to confirm trends and minimize trading risks. The sheer amount of information that this chart displays may also be overwhelming for beginners. For these traders, it's usually a good idea to become comfortable with more basic indicators before tackling the Ichimoku Cloud.