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Ichimoku Cloud

A chart that shows the stock price support and resistance levels, as well as trend direction and momentum

What is the Ichimoku Cloud?

The Ichimoku Cloud is a technical analysis method that was created by Japanese journalist Goichi Hosoda in the late 1960s. The Ichimoku chart shows the support and resistance levels, as well as other essential information such as trend direction and momentum. Compared to standard candlestick charts, the Ichimoku Cloud contains more data points, increasing the accuracy of forecast price moves.

The Ichimoku Indicator includes many lines and information that may be complicated for inexperienced traders to understand, but most traders who know how to read and interpret the chart use it as a key tool for trading.

 

Components of the Ichimoku Cloud

Several elements make up the Ichimoku Cloud. The elements consist of the following five moving averages:

 

1. Tenkan-Sen

The first component of the Ichimoku cloud is the Tenkan-Sen, which is represented by a red line on the chart. It is a moving average that is calculated by taking the average of the high and the low for the last nine periods. The market is deemed to be trending if the Tenkan-Sen is moving up or down. However, if the line moves horizontally, it indicates a ranging market. It is calculated as follows:

Tenkan-Sen = (9-Period Highest High + 9-Period Lowest Low) / 2

 

2. Kijun-Sen

The Kijun-Sen is a support/resistance line that acts as an indicator of price movements in the future. It is represented by a blue line. It is similar to Tenkan-Sen, but it takes a longer time into consideration, usually 26 periods compared to Tenkan-Sen’s nine periods. It measured by taking the average of the local highs and lows for the last 26 periods. When plotted on a chart, the Kijun-sen is usually lower than the Tenkan-sen since the former comprises longer periods than the latter.

Kijun-Sen= (26-Period High + 26-Period Low) / 2

 

3. Senkou Span A

Senkou Span is the average of the highs and lows of Tenkan-Sen and Kijun-Sen and is plotted 26 periods to the right. On a chart, the Senkou span A is represented by an orange line. If the security price is above the Senkou span A (orange line), the top and the bottom lines become the first and second support levels, respectively. Conversely, when the price moves below the Senkou span A, the bottom and the top line becomes the first and second resistance levels, respectively.

Senkou Span A = (Tenkan-Sen + Kijun Sen) / 2

 

4. Senkou Span B

It is calculated by taking the average of the high and low of the past 52 periods and plotting it 26 points to the right.

Senkou Span B = (52-Period High+ 52-Period Low) / 2

 

5. Chikou Span

The Chikou Span, also known as the lagging span, is represented by a green line. It is formed by taking the current price and shifting it back 26 periods to the left. If the Chikou span crosses the price action from the bottom-up, it demonstrates a buy signal. However, if the line crosses the price action from the top-down, it is a sell signal.

 

Ichimoku Cloud Signals

The cloud provides the trend direction, and it also acts as a support and resistance. It is formed by the two Senkou Span lines, A and B. The trend is dependent on the location of the price vis-a-vis the cloud. For example, when the price is above the cloud, the trend is up, while the trend is down when the price is below the cloud. If the price is in the cloud, the trend is flat.

Also, the strength of the trend can also be influenced by the position of Senkou span A and B. For example, when A moves above B, the trend is stronger in the bottom-up direction, while the opposite is true when Senkou span B moves above Senkou Span A.

 

Ichimoku Cloud
Source: Stockcharts.com

 

When the Tenkan-Sen line moves above the Kijun-Sen line, it illustrates a buy signal. For the situation to occur, the two lines and the security price must be above the cloud. On the other hand, when the Tenkan line (red line) intersects and goes below the Kijun-Sen line, it yields a sell signal. The two components and the price must also be located below the cloud. Traders should use other indicators like the Relative Strength Index to complement the Ichimoku Cloud indicator with the goal of maximizing their risk-adjusted returns.

 

Limitations of Ichimoku Clouds

One of the downsides of Ichimoku clouds is that they are based on historical data, and it means that the entry and exit signals may come at inopportune times. It is because the historical tendencies may not repeat in the future as traders may expect.

Also, the indicator provides trading information for only the period under analysis. It means that the indicator may produce false signals, which may result in lost trades. Also, the indicator may not account for larger trends.

 

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • How to Read Stock Charts
  • McClellan Oscillator
  • Three Best Stock Simulators
  • Triangle Patterns – Technical Analysis

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