Last Updated on October 10, 2022 by Oddmund Groette
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?
The Ichimoku indicator is 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.
In this post, we take a look at the Ichimoku indicator, and we end the article by backtesting an Ichimoku trading strategy.
What is the Ichimoku 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 developed in 1968. 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 a good practice of risk management, discipline, and following the rules of a trading plan then yes, the Ichimoku can be a good strategy.
The Ichimoku 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 Ichimoku?
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.
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
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.
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.
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.
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.
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 Strategy (Example And Backtest)