Ichimoku cloud is a type of technical analysis method that is often simply called Ichimoku. It is based on Japanese candlestick charting to predict future price movements.
Only in the 1960s did Ichimoku came to the attention of the public when a Japanese journalist named Ichimoku Sanjin, also known as Goichi Hosoda, released it publicly after three decades perfecting it.
The idea behind the Ichimoku Cloud Strategy is to use a moving-average based trend method to indicate where a stock is likely headed next.
In addition to price action, Ichimoku uses time as another element, and because greater data points are used, it is generally regarded as providing a clearer picture than Japanese Candlesticks.
How to Calculate the Ichimoku Cloud
The highs and lows are the highest and lowest prices seen during the period—for example, the highest and lowest prices seen over the last nine days in the case of the conversion line. Adding the Ichimoku Cloud indicator to your chart will do the calculations for you, but if you want to calculate it by hand, here are the steps:
• Calculate the Conversion Line and the Base Line.
• Calculate Leading Span A based on the prior calculations. Once calculated, this data point is plotted 26 periods into the future.
• Calculate Leading Span B. Plot this data point 26 periods into the future.
• For the Lagging Span, plot the closing price 26 periods into the past on the chart.
• The difference between Leading Span A and Leading Span B is colored in to create the cloud.
• When Leading Span A is above Leading Span B, color the cloud green. When Leading Span A is below Leading Span B, color the cloud red.
• The above steps will create one data point. To create the lines, as each period comes to an end, go through the steps again to create new data points for that period. Connect the data points to each other to create the lines and cloud appearance.
Components of the 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, often 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 usually represented by a blue line. The Kijun-Sen is similar to the Tenkan-Sen, but takes a longer time frame into consideration, usually 26 periods compared to Tenkan-Sens nine periods. It measured by taking the average of the highs and lows for the last 26 periods. When plotted on a chart, the Kijun-sen typically lags behind 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 lines become 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 from the bottom-up, it demonstrates a buy signal. However, if the line crosses the price from the top-down, it is a sell signal.
Ichimoku Cloud Signals
The cloud provides the trend direction, and it also indicates support and resistance levels. It is formed by the two Senkou Span lines, A and B. The trend is dependent on the location of 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 Ichimoku Cloud, the trend is flat or undetermined.
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.
When the Tenkan-Sen line moves above the Kijun-Sen line, this is a buy signal. Ideally, the two lines and the security price should be above the Ichimoku 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 should also be located below the cloud. Traders may 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 the Cloud
One of the downsides of the Ichimoku Cloud is that it is based on historical data. Historical tendencies may not repeat in the future as traders may expect.
Like any technical indicator, the Ichimoku Cloud may produce false signals. Also, depending on the time frame the indicator is applied to, it may not account for larger trends.
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