The Ichimoku Kinko Hyo, Ichimoku Cloud, Equilibrium Chart was developed by Japanese newspaper writer Goichi Hosoda in 1968, and it is mostly used by futures and equity traders than to forex traders. This indicator is quite powerful and innovative, worthy of greater attention than it is currently receiving in the trader community.
To understand how this indicator functions, we need to recall that the ichimoku cloud is a strategy more than an indicator. It combines two support/resistance levels to create a cloud, or reversal zone, and depends on the crossover of the tenkan and kijun sen to generate trade alerts. But since it is a strategy, it is not as versatile as some of the other, more basic tools like moving averages or the RSI.
A typical trading scenario is produced when the red and blue lines generate a crossover, as is shown on first and second vertical bars on the chart. The purple and reddish dotted areas, termed the cloud (or kumo), function as support/resistance levels where a possible reversal is indicated.
The Ichimoku Kinko Hyo indicator is calculated from four components with the following formulae:
1. Tenkan Sen: (Highest High + Lowest Low)/2 over 7-8 bars
2. Kijun Sen: (Highest High + Lowest Low)/2 over the past 22 bars
3. Senkou Span A: (Tenkou Sen + Kijun Sen)/2 plotted over 26 bars into the future
4. Senkou Span B: (Highest high + Lowest Low)/2 over the past 44 bars, plotted 22 bars ahead
Tenkan sen and kijun sen are moving averages. They are used in similar ways, with tenkan sen being the more sensitive than kijun sen. The senkou span A and B are the main features of the ichimoku indicator separating it from an ordinary oscillator. These two values come together to create a cloud, or kumo, which is used a support or resistance level by traders depending on market conditions.
Usage of Ichimoku Kinkyo
Once you have figured out how the Ichimoku cloud functions is very simple and easy to use. As was already said the indicator is more of a strategy than an indicator. It combines four separate tools into a single visual framework for trade decisions.
Trade signals are generated as the tenkan sen moves below or above the slower moving kijun sen, a little like the interaction of moving averages in the MACD, or the stochastics indicators. A bearish trend is indicated by the tenkan sen moving below the kijun sen, and vice versa. Once such a signal is generated, and we anticipate the development of a trend and open a position, the kumo (cloud) of the indicator comes into the picture. The cloud is the support/resistance zone of the trade. In a bearish position, we expect that the price action will remain outside of the kumo most of the time, and if it remains in that region for too long, it may be time to reconsider or close the trade. Conversely, we will maintain our position for as long as the support/resistance zone set by the cloud stays. This makes ‘letting profits run’ a much easier task than it is with a crossover/ support/resistance strategy, as the problems created by volatility are better handled by the ichimoku cloud.
Take profit orders can be placed at any point outside of the cloud. Stop-loss orders should be placed in or at the edge of the cloud, and money management methods must always take into account the possibility of maximum losses being incurred as the cloud support fails.
The Ichimoku cloud indicator is a complex tool that provides a lot of information when it is depicted on the chart. Two moving averages, and a layered support/resistance area make it possible to implement difficult strategies, but also makes the addition of any extra moving averages, vertical Fibonacci levels, or arbitrary support/resistance data superfluous.
The kumo, or cloud component of the indicator is useful in conditions of high market volatility where strict adherence to single support/resistance levels on the chart may result in lots of false signals and small failed trades. By providing a zone this indicator can be helpful in isolating more reliable signals from noise. We could easily construct a support/resistance zone with multiple Fibonacci indicators, or simple support/resistance lines, and decrease the number of generated signals by refusing to act on mere breaches of the outer and inner lines. The strength of the Ichimoku cloud against such a strategy is automation and speed. You have to depend on the same basic formulae in all market conditions, with minimal manual intervention, but also acquire greater flexibility in your decisions.
The advantages of the Ichimoku cloud are concision, automation, and simplicity. Its disadvantages are a lack of customizability, and blanket coverage for many possible market configurations. If you think that the particular market situation is suitable for trading with two support/resistance lines, and two moving averages, this indicator is a perfect choice. If you conclude that other or more tools are necessary, it is a good idea not to take much time with the Ichimoku cloud.