Getting to Know Ichimoku
Essentially made up of four major components, the application offers the trader key insight into forex market price action. First, we'll take a look at both the Tenkan Sen and Kijun Sen.
Tenkan Sen and Kijun Sen
What the trader will want to do here is use the crossover to initiate the position. Looking at our example in Figure 1, we see a clear crossover of the Tenkan Sen (black line) and the Kijun Sen (red line) at point X. This decline simply means that near-term prices are dipping below the longer term price trend, signaling a down trending move lower.
Figure 1 - A crossover in similar Western branded fashion
Now let's take a look at the most important component, the Ichimoku "cloud", which represents current and historical price action. It behaves in much the same way as simple support and resistance by creating formative barriers. The last two components of the Ichimoku application are:
Senkou Span A and Senkou Span B
The space between the Senkou Span A and Senkou Span B is known as the Kumo. Kumo later became known as the 'Ichimoku Cloud' since the most characteristic feature of the indicator is the Kumo (cloud), which is designed to represent various levels of support and resistance. In developing the cloud, Hosada realized support/resistance levels were not single lines drawn in the sand, since traders were often placing their trades at various distances from the support levels. Thus, since support was many layers deep from the offers/bids around the level, he created a cloud to represent the past levels of support/resistance.
The most basic theory of this indicator is that if the price is above the cloud, the overall trend is bullish while below the cloud is bearish, and in the cloud is non-biased or unclear. Lastly, when the price is above the cloud, then the top of the cloud will act as a general support level, and when price is below, the cloud base will act as resistance.
But remember the cloud has thickness, and thus resistance does as well, which by making these thicker reduces the risk of a false breakout. One more thing is that the thickness of the Kumo (cloud) also indicates the market volatility. A thin layer of cloud implies the current volatility is low whilst a thick cloud implies increasing volatility.
Let's take a look Figure 2's comparison. Taking our USD/CAD example, we see a comparable difference between the two. Although we see a clear support at 1.1522 in our more standard chart (Figure 2), we subsequently see a retest of the level. At this point, some trades probably will be stopped out as the price action comes back against the level, which is somewhat concerning for even the most advanced trader. However, in our Ichimoku example (Figure 3), the cloud serves as an excellent filter. Taking the volatility and apparent take back into, the cloud suggests a better trade opportunity on a break of the 1.1450 figure. Here, the price action does not trade back, keeping the trade in the overall downtrend momentum.
Figure 2 – Classic support and resistance break
Figure 3 – Ichimoku creates a better break opportunity
Chikou span
This feature suggests the market's sentiment by showing the prevailing trend as it relates to current price momentum. The interpretation is simple: as sellers dominate the market, the Chikou span will hover below the price trend while the opposite occurs on the buy side. When a pair remains bid in the market or is bought up, the span will rise and hover above the price action.
Figure 4 – Chikou helps to sort out market sentiment
Putting it All Together
Like everything else, there's no better substitute for learning but through application. Let's break down the best method of trading the Ichimoku cloud technique.
Taking our U.S. dollar/Japanese yen example in Figure 4, we will zoom in on a more recent scenario in Figure 5.
Figure 5 – Lines that tell a complete story
With the currency pair fluctuating in a range between 116 and 119 figures for the beginning of the year, traders were anxious to see a break out of the persistent range. Here, the cloud is a product of the range-bound scenario over the first four months and stands as a significant support/resistance barrier. With that established, we look to the Tenkan and Kijun Sen. As mentioned before, these two act as a moving average crossover with the Tenkan representing a more short-term moving average and the Kijun acting as the base line. As a result, the Tenkan dips below the Kijun, signaling a decline in price action. However, with the crossover occurring within the cloud at Point A in Figure 5, the signal remains unclear and will need to be clear of the cloud before an entry can be considered. We can also confirm the bearish sentiment through the Chikou Span, which at this point remains below the price action. Conversely, if the Chikou was above the price action, it would confirm bullish sentiment. Putting it all together, we are now looking for a short position in our U.S. dollar/Japanese yen currency pair.
Figure 6 – Place the entry ever so slightly in the cloud barrier.
Because we are equating the cloud to a support/resistance barrier, we will want to see a close of the session below the cloud before initiating any type of short sell position. As a result, we will be entering at Point B on our chart. Here, we have a confirmed break of the cloud as the price action stalls on a support level at 114.56. The trader, at this point, can opt to place the entry at the support figure of 114.56 or place the order one point below the low of the session. Placing the order one point below would act as confirmation that the momentum is still in place for another move lower. Subsequently, we place the stop just above the high of the candle within the cloud formation. In this example, it would be at Point C or 116.65. The price action should not trade above this price if the momentum remains. Therefore, we have an entry at 114.22 and a corresponding stop at 116.65, leaving our risk out at 243 pips. In keeping with sound money management, the trade will have to have a minimum of a 1:1 risk/reward ratio with a preferable 1:2 risk/reward for legitimate opportunities. In our example, we will maintain a 1:2 risk/reward ratio as the price moves lower to hit a low of 108.96 before pulling back. This equates to roughly 500 pips and a 1:2 risk to reward - a profitable opportunity. One key note to remember: notice how the Ichimoku is applied to longer time frames, in this instance the daily. With the volatility in shorter time frames, the application will tend not to work as well as with many technical indicators.
To Recap:
- Refer To The Kijun / Tenkan Cross - The potential crossover in both lines will act in similar fashion to the more recognized moving average crossover. This technical occurrence is great for isolating moves in the price action.
- Confirm Down / Uptrend With Chikou - Confirming that the market sentiment is in line with the crossover will increase the probability of the trade as it acts in similar fashion with a momentum oscillator.
- Price Action Should Break Through The Cloud - The impending down/uptrend should make a clear break through of the cloud of resistance/support. This decision will increase the probability of the trade working in the trader's favor.
- Follow Money Management When Placing Entries - By adhering to strict money management rules, the trader will be able to balance risk/reward ratios and control the position.
This indicator is intimidating at first, but once the Ichimoku chart is broken down, every trader from novice to advanced will find the application helpful. Not only does it mesh three indicators into one, but it also offers a more filtered approach to the price action for the currency trader. Additionally, this approach will not only increase the probability of the trade in the forex markets, but will assist in isolating only the true momentum plays. This is opposed to riskier trades where the position has a chance of trading back former profits.
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