Ichimoku Cloud trading strategies explained

A first look at the Ichimoku Cloud indicator can be quite overwhelming. The following article looks to demystify this versatile indicator by breaking down its component parts and then formulating a basic trading strategy for consideration.

Charts
Source: Bloomberg

The Ichimoku Kinko Hyo charting system was developed by Japanese journalist Goichi Hosoda in the late 1930s and has since been used for stocks, commodities, futures and forex trading. The versatile indicator lets traders identify trends and look for trade signals very quickly. It defines support and resistance, identifies trend direction, and gauges momentum.

What is the Ichimoku Cloud? (also referred to as Kumo)

The cloud aspect of the Ichimoku Indicator (labelled below) is the coloured area on the chart and is used to easily identify the general market trend direction. The colouration of the cloud can be defaulted to any combination, however, for the sake of the current exercise, will be red or green.

The cloud provides two filters in determining trend:

  •      - An uptrend using this technique can be defined as the price trading above the cloud and the cloud trading in green territory
  •      - A downtrend using this technique can be defined as the price trading below the cloud and the cloud trading in red territory.

Identifying the underlying trend is the first filter in trading with the Ichimoku indicator. If the underlying trend bias is identified as up, traders will now only be looking for long/buy entries into the market. If the underlying trend bias is identified as down, traders will now only be looking for short/sell entries into the market.

The lagging line (also referred to as Chikou span)

The lagging line is the current closing price shifted back 26 periods (26 being a default number). While the Ichimoku cloud is used to gauge trend, the lagging line is often used as a confirmation of the trend direction and/or trigger for entry and exit signals.

For confirmation of an uptrend (determined by the cloud), a trader might look for the lagging line to be trading above both the cloud and the price of the market concerned. For bullish trade considerations, a trader might look for the lagging line to cross up through the price for a long/buy signal, while a cross back down through the price might be considered a signal to exit the trade.

For confirmation of a downtrend, a trader might look for the lagging line to be trading below both the cloud and price of the market concerned.  For bearish trade considerations, a trader might look for the lagging line to cross down through the price for a short/sell signal, while a cross back down through the price might be considered a signal to exit the trade.

The trigger line and the base line (also referred to as the Tenkan Sen and Kijun Sen)

These lines are very similar to moving averages in nature, although the calculation thereof is slightly different.

The trigger line is derived by finding the mid-point of the highest high and lowest low over the last nine periods (nine is the default period used for this indicator). 

The base line is derived by finding the mid-point of the highest high and lowest low over the last 26 periods (26 is the default period used for this indicator).

These lines are most commonly used together with crossovers (in line with the trend bias determined by the cloud) providing entry and exit signals. 

A bullish buy (long) signal is considered when the trigger line crosses above the base line, while a cross of the trigger line below the base line might consider an exit signal for the trade.

A bearish sell (short) signal is considered when the trigger line crosses below the base line, while a cross of the trigger line above the base line might consider an exit signal for the trade.

Example Ichimoku cloud trading strategies

In summation, a bullish trade setup considers:

  1. Establishing an uptrend, where the price is trading above the cloud and the cloud is trading in positive territory (green, although colours settings may vary)
  2. Further confirmation of trend can be considered with the lagging line trading above the historical price
  3. Entry signals may be considered with the trigger line crossing above the base line
  4. Exit signals may be considered with the trigger line crossing below the base line

In summation, a bearish trade setup considers:

  1. Establishing an downtrend, where the price is trading below the cloud and the cloud is trading in negative territory (red, although colours settings may vary)
  2. Further confirmation of trend can be considered with the lagging line trading below the historical price
  3. Entry signals may be considered with the trigger line crossing below the base line
  4. Exit signals may be considered with the trigger line crossing above the base line

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