The names of mathematicians and statisticians dominate the list of technical analysis innovators; it's not often we see newspaper writers on this list, but Tokyo newspaper writer Goichi Hosoda is an exception to the rule. In the years before World War II, Hosoda—with the help of several assistants—developed the Ichimoku Kinko Hyo, or "equilibrium chart at a glance technique".
Released in 1968, the technique was designed to illustrate where prices were likely to go and when to trade. In this article, we look at this extraordinary technique and how you can apply it to enhance your trading. The Ichimoku charting technique did not gain international attention until the 1990s. It has since been applied by traders worldwide.
Constructing an Ichimoku Chart
Let's see what these lines represent, and how they are plotted:
- Tenkan-Sen (Conversion Line) - Red
- Kijun-Sen (Base Line) - Blue
- Chikou Span (Lagging Span) - Green
- Senkou Span A - Orange
- Senkou Span B - Grey
Ichimoku uses three key time periods for its input parameters: 9, 26, and 52. The time frame is most often measured in days; however, Ichimoku can be modified to be any time frame as long as it is consistent throughout all calculations.
We should note that, when Ichimoku was created in the 1930s, a trading week was 6 days long. These parameters, thus, represent one and a half week, one month, and two months. Now that the trading week is 5 days, one may want to modify the parameters to 7, 22, and 44.
Ichimoku Analysis in Trading
First, let's take a look at an Ichimoku chart so we have a visual point of reference.
Tenkan Sen and Kijun Sen
Tenkan Sen and Kijun Sen are quite similar to moving average studies, buy and sell signals are generated when short-term line (Tenkan-Sen) crossover the longer-term line (Kijun-Sen).
A buy signal is generated when the Tenkan-Sen crosses above the Kijun-Sen from below. On the other hand, a sell signal is generated when the Tenkan-Sen crosses below the Kijun-Sen from above. However, one clear advantage of using Ichimoku Kinko over the moving average crossover is that the area where the Tenkan-Sen crosses the Kijun-Sen will dictate the relative strength of that buy/sell signal.
If a buy signal (i.e. the Tenkan-Sen crosses above the Kijun-Sen from below) happens above the Kumo (or cloud), this would be considered as a very strong buy signal as the cloud is representing support / resistance area.
Similarly, if a sell signal (i.e. the Tenkan-Sen crosses below the Kijun-Sen from above) occurs below the cloud, this would be considered as a very strong sell signal. If the buy/sell signal occurs inside the Kumo, this signal will be treated as normal.
Finally, if the buy signal happens below the cloud, it will be viewed as a weak signal whilst if the sell signal occurs above the cloud, it will be treated as a weak signal also.
Senkou Span A and Senkou Span B
The space between the Senkou Span A and Senkou Span B is known as the Kumo (or the cloud). The Kumo is getting more popular among chartists to identify support and resistance area. When price is trading above the Kumo, the prevailing trend is said to be up and the Kumo will be treated as the support area whilst
if price is below the Kumo, the trend is said to be down and the cloud will become resistance area instead.
If the price is below the Kumo, the lower line (i.e. the Senkou Span A) acts as the first resistance level, and the upper line (i.e. Senkou Span B) becomes the second resistance level.
If the price is above the cloud, its upper line (i.e. the Senkou Span A) acts the first support level, and the lower line (i.e. the Senkou Span B) becomes the second support level.
One more thing is that the thickness of the Kumo also indicates the market volatility. A thin layer of cloud implies the current volatility is low whilst a thick cloud implies increasing volatility.
Chikou Span
The Chikou Span originally is used to indicate the relative strength of the buy/sell signals generated by Tenkan-Sen and Kijun-Sen, if the buy signal happens above the Chikou Span, it will be treated as a strong signal and vice versa. However, in our approach, we prefer and remove the Chikou Span (which leave a chart a bit more clear) and simply use the other 4 lines.
Why isn't Everyone Making Money?
The technique gives traders an easy way to determine buy and sell signals, support and resistance levels, trends, and signal strength. However, the charting method is not without its drawbacks, such as its need for empirical decision making and time period definitions, and its indications to make high frequency trades.
- Empirical decision making – As with most technical analysis, empirical decision making is required when determining the time period to use. Keep in mind that the time periods are the only thing making this technique different from a moving average analysis, so it is critical to fine-tune (optimize).
- 24-hour markets – Markets which operate 24 hours a day, like the currency market, are without an actual set open and close price. To get around the problem, traders often make the calculations in real-time or use the open and close times that are closely associated with the currency pair being traded. For example, for the EUR/USD, it would be wise to use the New York open and close since that is when the majority of trading occurs.
- Occasional short time between trades – There will be times when the buy and sell signals occur within close proximity. In a world without commissions or bid/ask spreads, this would not be a problem; however, quick trades like this can cause commissions to eat into your profits.
Conclusion
Most traditional technical analysis techniques are based on the open, high, low, close or average price. Others may use volatility while fixed scales such as Fibonacci numbers have also been applied. But the results are the same. Support and resistance levels are always depicted as a point or a line.
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