Ichimoku Cloud Trading Strategy: Rules & Backtest
The Ichimoku trading strategy uses a technical analysis indicator that defines support and resistance levels, shows the trend direction, and gauges the momentum of the trend. It does this by plotting multiple averages on the price chart, which forms a ‘cloud’ that indicates where the price may find support or resistance in the future.
Technical indicators are used by most traders in the financial markets. One of the challenges faced when using most indicators is the issue of false signals, which is what the Ichimoku Kinko Hyo tries to solve. But what is the indicator made of? What is an Ichimoku trading strategy?
In this post, we look at the Ichimoku indicator and end the article by backtesting an advanced Ichimoku trading strategy.
Key takeaways:
- The Ichimoku Cloud is a technical analysis indicator that defines support and resistance levels, gauges momentum, and provides trading signals.
- Backtests reveal that the Ichimoku strategy does a good job of reducing drawdowns.
- Ichimoku works on most assets, but it mostly fails to beat buy and hold.
What is the Ichimoku cloud indicator?
The Ichimoku Cloud is a technical analysis indicator that defines support and resistance levels, gauges momentum, and provides trading signals. It does this by plotting multiple averages on a chart. Some of the averages form a “cloud” that attempts to forecast where the price may find support or resistance in the future.
In Japanese, the full name of the indicator is the ‘Ichimoku Kinko Hyo’, which roughly means ‘one look equilibrium chart’ — because, with just one look, traders can receive a range of information.
The indicator was presumably developed in 1968, although we have seen posts it was developed as early as the 1930s. Although most of the technical indicators are created by mathematicians or statisticians, the Ichimoku was created by Goichi Hosoda, a Tokyo-based newspaper writer alongside assistants who were doing the actual math behind it. The indicator is employed by several Japanese traders and some western traders because it offers many confirmations of price actions that filter for higher probability trades.
At first glance, the Ichimoku can be intimidating because of the numerous lines drawn on the chart. However, a quick breakdown of each component makes it a more commonly accepted tool. Here are the components:
- Kijun Sen (Blue Line). The Kijun sen or the standard line is plotted by calculating the average of the highest high and lowest low of the past for the last 26 periods.
- Tenkan Sen (Red Line). The Tenkan sen is plotted by calculating the average of the highest high and lowest low for the last 9 periods. Both the Kijun and Tenkan sen can be used for a moving average crossover signal.
- Chikou Span (Green Line). The Chikou span is used to gauge market sentiment. It is computed by taking the most recent closing price of the last 26 periods behind the current price. This line tells you where the current trend is with momentum. Interpreting the Chikou span is quite simple – as buyers dominate the market, the line will hover above the price. Conversely, the line will go below the price trend as sellers mount more pressure.
- Senkou Span (Ichimoku Cloud). The Senkou span is comprised of two lines: Span A and Span B line. The span A is plotted by summing the Tenkan Sen and Kijun Sen and then dividing it by 2. The result is then plotted 26 periods ahead of the price action. The span B is plotted by taking the sum of the highest high and lowest low and dividing by 2. The result is taken over the last 52 periods and then plotted 26 periods ahead of the price action. The area between the two lines is what is called the Ichimoku cloud or Kumo. The line is thicker than the traditional support and resistance line, the cloud serves as a volatility buffer. The thicker cloud gives volatility-based support and resistance instead of the usual thin support and resistance. A move above or below the cloud or a breakthrough is an indication of a higher probability of trade.
Is Ichimoku a good strategy?
How do you know a profitable strategy? Is the percentage profitable or the profit factor? Does it outperform the broad market like the S&P 500?
These are all subjective questions that may have different answers. To help clarify this let us consider the following points.
A good strategy can lose money not because it is bad but because of how a trader uses it. For example, a scalper can have a high win rate and still end up losing their capital. Careless risk management practices can also lead to consecutive losses.
However, if a trader approaches the market with good practice of risk management, discipline, and following the rules of a trading plan then yes, the Ichimoku can be a good strategy. That said, you need to backtest it. Our experience is that the great majority of traders don’t have a positive expectancy in the first place. You can have all the risk management and psychology you want, but nothing of that help if you don’t have e a sound strategy.
The advanced Ichimoku trading strategy gives you the advantage of knowing three things in the market: trend, support and resistance, and the strength of a trend. This makes it a formidable tool in the hands of the right trader. However, you need to backtest it to know if it actually makes money for the market you are trading.
What is the best time frame for an advanced Ichimoku? trading strategy?
Different Ichimoku traders use the indicator on different timeframes. Scalpers and day traders use it on intraday timeframes, while swing traders and position traders use it on larger timeframes.
But when creating a quantified strategy, you would want to know the best timeframe for the indicator. Well, the only way to find out is to backtest it. That said, we believe the best time frame in trading is daily bars:
- What Is The Best Time Frame For Candlesticks?
- Which Time Frame Is Best In Trading? [Day trading, Swing Trading & Trend Trading]
How do you use Ichimoku effectively?
As stated before, the Ichimoku is made up of four components, and understanding how each of them is interpreted is crucial to using the indicator to its full potential. Let’s now take a look at how to make use of the various components.
The Ichimoku Cloud strategy
Interpreting the Ichimoku cloud is quite straightforward. When the price is above the cloud, it indicates an uptrend. In the same fashion, a downtrend is characterized when the price is below the cloud and in red territory.
Trend and swing traders who use the indicator will consider a long position when the price is above the cloud and a sell trade when the price is below the cloud. The cloud is also used to gauge the volatility in the market. High volatility in the market tends to be characterized by a thick cloud while a thin cloud is a sign of dwindling volatility.
Below is an illustration of the Ichimoku cloud strategy.
In the hourly chart of the EUR/JPY above, you can see the two breakout scenarios at play. The first one is the bearish break below the cloud. You can see the price breaking through and closing below the cloud indicating a downtrend, which, as you can see, lasted for quite a while.
Later, a bullish breakout occurred, as the price rose above the cloud. The uptrend that followed was also sustained for a while. This is the basic interpretation of the cloud and how to use it in your trades.
Tekan/Kiju Crossover
The Tekan Sen and Kiju Sen can generate a crossover signal, just as the moving average crossover. Additionally, it can serve as further confirmation of price action. Below is an illustration of a cross.
Looking at that chart again, we can see that a cross of the Kijun/Tenkan line further confirms the uptrend and downtrend. You can trade this in isolation like the moving average cross or use it in addition to the cloud breakout strategy to help you filter for higher probability in your trade.
Chikou Span
The Chikou span can be used to confirm the trend. When the line crosses the price to the upside, it is considered bullish and would confirm an upward price breakout of the Ichimoku cloud. It usually happens about the same time, but sometimes, it can precede the breakout, serving as an early indication of an upward movement.
On the other hand, when the line crosses the price to the downside, it is considered bearish and would confirm a downward price breakout of the Ichimoku cloud. This might happens about the same time as the breakout, but sometimes, it can precede the breakout, serving as an early indication of a downward movement.
Senkou Span
The Senkou span can be used as a support and resistance line. Depending on whether the price is, above or below, the two lines will serve as two levels of support and resistance.
Using the Ichimoku indicator to create a quantified strategy
The Ichimoku indicator has different components and any of them can be used to create a quantified systematic strategy. You can choose any aspect you like, such as the Tekan Sen and Kiju Sen crossover signal, the Cloud breakout, or the Chikou Span crossing, and create a strategy from it and then backtest it.
You can even create several strategies with each of the components and backtest them to find the one that works best for the market you want to trade.
Alternatively, you can combine any of the signals to form a strategy. For example, you may use the Tekan Sen and Kiju Sen crossover signal but with a Cloud breakout filter. That is, after a crossover signal, your algo takes a long position only if the price has crossed above the cloud. On the flip side, it takes a short position, only if the price has crossed below the cloud.
Whichever way you use the Ichimoku indicator to create a strategy, make sure you backtest it and forward-test it before putting your money on the line.
Ichimoku trading strategy (Example And Backtest)
Let’s go on to backtest an Ichimoku trading strategy. It’s not among the easiest to backtest, but we’ll give it a try.
We made Amibroker code to show how the “clouds” might look like:
As you can see, there are many colors. But does it work?
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Let’s look at the equity curve (equity curve trading) of the asset that performed the second best (QQQ) compared to the buy and hold strategy:
QQQ spends 63% of the time invested in the market and thus we can argue the CAGR is 12.13% (7.7% divided by 0.63). Click here to read more about trading statistics and trading performance statistics.
Let’s look at the equity curve of the MDY (S&P Midcap 400):
Max drawdown is less than half compared to buy and hold – which is pretty impressive. Just like QQQ, the strategy is invested around 65% of the time, thus indicating an adjusted return of about 10%, which is slightly below the buy-and-hold return.
List of trading strategies
You can get the code for the Ichimoku trading strategy and plenty of other strategies.
We have written over 800 articles on this blog since we started in 2012. Many articles contain specific trading rules that can be backtested for profitability and performance metrics.
The trading rules are compiled into a package where you can purchase all of them (recommended) or just a few of your choice. We have hundreds of trading ideas in the compilation.
The strategies are taken from our list of different types of trading strategies. The strategies are an excellent resource to help you get some trading ideas.
The strategies also come with logic in plain English (plain English is for Python traders).
For a list of the strategies we have made please click on the green banner:
These strategies must not be misunderstood for the premium strategies that we charge a fee for:
FAQ Ichimoku trading strategy
Let’s end the article with a few frequently asked questions about the Ichimoku trading strategy:
What is the Ichimoku trading strategy?
The Ichimoku trading strategy is a technical analysis system used by traders to identify support and resistance levels, trend direction, and momentum. The Ichimoku system was developed by Goichi Hosoda, a Japanese journalist, in the late 1930s.
The system consists of five different components which are used to analyze the price movements of a given asset. These components are the Tenkan-Sen, Kijun-Sen, Senkou Span A, Senkou Span B, and the Chikou Span.
What are the components of the Ichimoku trading strategy?
The components of the Ichimoku trading strategy are the Tenkan-Sen, Kijun-Sen, Senkou Span A, Senkou Span B, and the Chikou Span.
The Tenkan-Sen is the average of the highest high and the lowest low over the past nine periods.
The Kijun-Sen is the average of the highest high and the lowest low over the past twenty-six periods.
The Senkou Span A is the average of the Tenkan-Sen and the Kijun-Sen, shifted forward twenty-six periods.
The Senkou Span B is the average of the highest high and the lowest low over the past fifty-two periods, shifted forward twenty-six periods.
The Chikou Span is the closing price shifted back twenty-six periods.
How does the Ichimoku Clod trading strategy work?
The Ichimoku trading strategy supposedly works by helping traders identify support and resistance levels, trend direction, and momentum.
The Tenkan-Sen and Kijun-Sen lines are used to identify support and resistance levels. When the Tenkan-Sen line crosses above the Kijun-Sen line, it indicates a bullish trend.
When the Tenkan-Sen line crosses below the Kijun-Sen line, it indicates a bearish trend. The Senkou Span A and Senkou Span B lines are used to identify the trend direction.
When the Senkou Span A line is above the Senkou Span B line, it indicates a bullish trend. When the Senkou Span A line is below the Senkou Span B line, it indicates a bearish trend.
The Chikou Span is used to identify momentum. When the Chikou Span is above the current price, it indicates a bullish momentum. When the Chikou Span is below the current price, it indicates a bearish momentum.
What are the benefits of using the Ichimoku trading strategy?
The Ichimoku trading strategy is a comprehensive technical analysis system that can be used to analyze any type of asset. It is relatively easy to use and understand, and it provides traders with an effective way to identify support and resistance levels, trend direction, and momentum. That said, it requires a bit of coding to make 100% quantifiable trading rules.
Moreover, the Ichimoku trading strategy can be used to identify potential trade entry and exit points.
What are the risks of using the Ichimoku trading strategy?
As with any trading strategy, there are risks associated with the Ichimoku trading strategy. The most significant risk is that the signals generated by the Ichimoku system may not be accurate and reliable, and as such, traders should always use caution when making trading decisions.
You should always backtest your trading ideas. The backtests we did earlier in the article suggest that the Ichimoku trading strategy is not among the best. Thus, we believe a backtest can save you both money and time.
Ichimoku trading strategy – conclusion
We backtested the Ichimoku trading strategy on a wide range of assets. By following the trading rules you spend less time in the market and you avoid much of the drawdowns. But in most cases, you also underperform the risk-adjusted buy-and-hold returns. Just like most things in trading, it’s all a trade-off.