Ichimoku Cloud Explained: Use Ichimoku to Spot Trend Reversals
Trading is difficult. Price action is often erratic. Attaching meaning to every price bar usually does more harm to your account than good. However, as modern markets matured over the past 70 years, traders discovered one truth they respect and rely upon to support their trading. Markets sometimes trend.
Think of a trend as the manifestation of momentum in a market, i.e., sustained price changes in a specific direction over time caused by a temporary imbalance in supply and demand. On a chart, this momentum results in the price painting a series of higher highs and higher lows in an uptrend; or a series of lower highs and lower lowers in a downtrend. In addition, trends usually extended for relatively long periods of time, usually for far longer than anyone expects.
All that to say, one can understand then the value of having a consistent, objective method to determine if a market is actually trending. The benefit of Ichimoku to traders is three-fold:
1. a trader can instantly tell if a market is trending
2. a trader can determine when an existing trend is worth joining
3. a trader can spot when an existing trend ends
The Value of Ichimoku When Trading Trend Reversals
Ichimoku is one of thousands of technical chart indicators available for free with many charting packages. However, unlike almost all other indicators, Ichimoku is a completely self-sufficient trend trading system. No other indicator and no data other than a market’s price over time is required to be able to use Ichimoku effectively.
Goichi Hosoda created Ichimoku to be a “one glance” indicator so that in a few seconds a trader is able to determine whether a tradable trend is present or if one should wait for a better opportunity to take a trade.
(Side Note: I subscribe to the idea that a trader’s job is mostly to wait. Wait for the right conditions, enter a trade, then wait to see what happens. Analyzing a market correctly is critical to a trader’s success, but analysis should only take about 20% of a trader’s time, in my opinion. Managing open positions, again mostly waiting and watching what happens, takes the other 80%. If nothing else, then, using the Ichimoku system encourages one to cultivate patience which is key to winning the trading game.)
Before we dive into the components of the indicator, though, there are a few points that will help you understand how to interpret what Ichimoku is telling you when you look at it on a chart.
1. Ichimoku can be used in rising and falling markets.
2. Ichimoku can be used on all time frames for any liquid trading symbol.
3. Ichimoku lines should be ignored when they are interacting with the price. For example, when the price is in the cloud or moving back and forth to either side of the cloud on the time frame you’re using to analyze price, or when the Chiko Span Lagging Line is touching the price candles, all of these are signals mean the same thing: the market is ranging, or in a non-trending condition.)
The Five Lines of Ichimoku
Ichimoku is built with five lines. A trader compares the current price to these five lines to determine three crucial conditions needed to successfully trade in a trending market:
• The primary trend on the time frame used for analysis (the base time frame)
• Future potential support and resistance
• Likely points in price and time to confirm a trend reversal
The five lines provide a simple and consistent framework on a price chart that allows a trader to see the current price in relation to multiple layers of the current and historical trends in real-time. As market conditions change, Ichimoku automatically adjusts the view for you, so that you know the condition of a market at all times.
If the market is in a trend, the indicator shows the strength of the current trend.
Always Start with the Cloud
In Chart 1, the area between Senko Span A (#3) and Senko Span B (#4) is the Cloud. Depending on the charting package, the color of the Cloud will likely change in a Bullish or Bearish Environment. In Chart 1, a Bullish Cloud is colored light gray. A Bearish Cloud is dark gray.
The Cloud itself is created from the two Senko lines, Span A and Span B. To understand how the Senko lines are calculated, let’s take a look at each of the five lines in detail.
1. Tenkan-Sen or Turning Line (9 period Price midpoint)
- Similar to a 9-period moving average, but is not calculated the same way
- Midpoint of the distance between the high and low of the most recent 9 price bars (including current bar)
- (9 Bar High + 9 Bar Low)/2
- Shortest and thus the fastest of the Ichimoku trend lines
- The Price breaking above or below the Tenkan-Sen line is the first signal of a change in trend momentum
The Tenkan-Sen line represents the ‘break-even’ price over the last 9 bars or candles. In other words, if the current price equals the Tenkan-Sen line value, that means that the traders who bought at that price 9 candles ago are even in their trades, and the other traders who sold at that price are also even in their trades.
This is very valuable information to have because if price is in equilibrium, it means that we know that we don’t know if the market will go up or down from there. In other words, we know that no trend momentum exists within the last 9 periods.
So we can easily and accurately tell if there is short-term trend momentum in a market, or if there is no trend momentum. This means that, once the price breaks the Tenkan-Sen up or down, we can know, at least within the last 9 price bars, whether there is an uptrend or downtrend in that time. And we know as trend followers that we don’t want to fight a trend.
When the price moves above Tenkan-Sen, traders who bought the market at that price 9 periods ago are winning. Hence, for a short period of time, a trader can expect that the price will continue to trend to the upside. The opposite is true when price is below the Tenkan-Sen. In that case, sellers are winning.
Either way, we know that if price is above or below the Tenkan-Sen, that market is trending up or down within the last 9 time periods on the chart.
This is the first building block of Ichimoku.
2. Kijun-Sen or Base Line (26 period midpoint)
- Similar to a 26-period moving average
- Midpoint of last 26 bars (including current bar)
- (26 bar High+ 26 bar Low/2)
- Longer trending line than Tenkan-Sen Line
- Price breaking the baseline up or down is additional confirmation of trending momentum in that direction over the last 26 bars
3. Senko Span A or Leading Cloud Line
- Midpoint between Tenkan Line & Kijun Sen Line, projected 26 bars ahead
- (Trigger Line + Base Line) / 2
- Forms top of Cloud in an uptrend, base of Cloud in downtrend
- Faster of the two lines forming the Cloud
- Angle is steeper when the Tenkan Line and the Kijun Line move in the same direction
4. Senko Span B or Lagging Cloud Line
- Midpoint of most recent 52 bars, projected 26 bars forward
- (52 bar high + 52 bar low) / 2
- Creates the base of the Cloud in an uptrend, the top of the Cloud in an downtrend
- Slower of the two lines forming the Cloud
5. Chiko Span or Lagging Line
- Current price shifted back 26 bars
- Essential Indication of Momentum
- Only Ichimoku line to reflect just the price as opposed to the midpoint of a range of prices
- Compares current price with four Ichimoku lines 26-periods earlier
- Helpful tool to help confirm trend momentum
- Look for lagging line to break cloud opposite from prior trend to confirm a reversal of momentum
Guide to Spotting Reversals with Ichimoku
Ichimoku is best used to find markets and time frames where price is trending strongly in one direction. The indicator provides visual clues through the Cloud, Chiko Span, and Tenkan-Kijun lines to help traders enter and stay in those strong trends to extend profits and minimize losses as much as possible.
Ichimoku is so good at identifying trending markets that it can also be used to recognize when a reversal is developing.
When I want to know if an existing trend is really in the process of reversing, I focus on the Chiko Span (Lagging Line). Look at this example chart.
- In Chart 2, Downtrend A was strong for quite some time, but then momentum slowed and started to range.
- We know this because the price started to move above the Tenkan Sen and Kijun sen lines, both of those lines crossed each other, the price went into the cloud, and the Chiko Span lagging line moved into the candles and broke through price as well.
- Then, the price broke through the other side of the cloud. That is the first signal that a new trend may be starting in the opposite direction of the previous trend – the definition of a trend reversal.
- To confirm the turn has really taken place, I look for the Chiko Span to also break through the cloud, along with the Tenkan Sen and Kijun Sen lines which should be crossed in the direction of the new trend, with the Tenkan Sen leading the Kijun Sen.
Manage An Ichimoku Trade Position
Let’s say you used Ichimoku to enter a strong trend. What do you do now? There are 4 possible scenarios you can consider.
1. Set a profit target, then close the trade when price hits your target. If you have a price target, manage your risk by adjusting your stop at least to break even as the market moves in your favor to limit your risk as you wait to see if your profit target gets hit. I wait until I am in profit by at least 2x the amount of my initial risk before moving my stop to break even. This is because the market almost always retraces right after an impulsive trend wave, and I don’t want to get stopped-out too soon if the trend is going to continue in my favor later later.
2. Don’t set a profit target, but instead ride the trend until Ichimoku shows you that a reversal is developing. If you are riding the trend until it ends, you would seek to stay in the trend until price either hits a trailing stop, or preferably until the Chiko Span lagging line breaks the other side of the cloud, which would show you with a high probability that the trend may be reversing.
3. The market momentum does not continue in the direction of the trend after you enter, but instead hits your stop loss first. You just lose that particular trade. Oh, well. Next please.
4. The trend is clean, but then you notice that the Chiko Span is starting to interact with price, and then price crosses the Tenkan-Sen and/or the Kijun-Sen. This is a warning sign. This means that the trend momentum is weakening, and the market could be entering a consolidation/ranging period. This is almost always a time when you may want to take some profit off the table, if you are in profit, make sure you have moved your stop to break even if you can, or close the position entirely. This could be an early sign of a trend reversal heading your way.
Ichimoku can be used on the time frame of your preference. I would recommend, however, to stick to using at least the 1-hour time frame or higher for your base trend analysis and trade management.
The Ichimoku rules work the same way no matter what time frame you use to trade, but trading on lower time frames usually means you trade more frequently. Trends on lower time frames don’t last as long as trends do on higher time frames. which means you are paying commissions/spread to your broker quite often. Remember that if you aren’t careful, your trading costs can easily destroy any profits you make, and can cause you to lose money.
Ichimoku is best at showing strong trends on the time frame you like to analyze. Ichimoku does this by effectively rendering a picture of the market using the Cloud, the short-term and the mid-term trend lines, Tenkan-Sen and Kijun-Sen, respectively, along with momentum visualization with the lagging line.
Regardless of the time frame you are trading, if you have a strong trend and momentum working for you, and you manage your trade risk properly, your odds of growing your trading account balance over time greatly increase.
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Good luck with your trading!