One interesting method that does just that, and as such should always grace the precious real estate of trading screens, is the Ichimoku Kinkou-Hyo. Although this technique has seen its popularity ebb and flow, it remains a well-kept secret in trend-following. The “cloud,” as this technique is known informally, is a useful method of gauging the health of trends and support and resistance levels.
The Ichimoku Kinkou-Hyo was designed by Tokyo newspaper writer Goichi Hosoda before World War II as a comprehensive forecasting method for all financial markets. American culture likes to abbreviate names, so it comes as no surprise that it popularly became known simply as Ichimoku in U.S. shorthand. In translation, the study means “one look at the equilibrium prices.” To produce support and resistance areas and directional changes, the Ichimoku combines midpoints of historical highs and lows at different lengths of time with a time cycle.
The Ichimoku system consists of five lines: trend (or kijun in Japanese), signal (tenkan), lagging (chiku) and the cloud, which consists of two leading lines. “Trend signs” (below) shows an example of the Ichimoku on the weekly EUR/USD chart. In it, the Ichimoku forecasts the health and directional changes of three trends. It’s helpful to look at these five lines individually.
If the trend line is heading down, then the market should decline as well; when the trend line advances, the market also should advance. Consider the trend line (green) plotted on the daily EUR/USD chart in “Crisscross” (below). The trend line follows the market, not the other way around. The market turns well before the trend line does, and can diverge significantly from the trend line. This is very similar to a moving average crossover.
We also notice that when the market diverges too far from the trend line, it will reconverge. Once the currency crosses the trend line, it is a confirmation of the directional change. Just like standard analysis, support turns into resistance and resistance into support. At the end of this chart, the euro is far from the trend line, so the risk is on the downside. If used independently, the trend line works best for identifying overbought and oversold conditions.
The formula for the trend (kijun) line is as follows:
Trend = (highest high + lowest low) / 2 for the past 26 days
The signal line works in conjunction with the trend line. A crossover above the trend line gives a buy signal and a crossover below the trend line provides a sell signal. The signal line is the dark red line in “Crisscross.”
The formula for the signal (tenkan) line is calculated as follows:
Signal line = (highest high + lowest low) / 2 for the past nine days
Without exception, the signals to sell and to buy will be late relative to the start of the downward and upward moves. This is because they are lagging indicators. They work to confirm, not forecast.
Now that we know the formulas for the trend and signal lines, we can compare them to moving averages for 26 and nine days. They are a little different than the averages in their lack of smoothness, but essentially they are similar. Therefore, these Ichimoku lines work best in trending markets.
The lagging line is important for the entire Ichimoku outlook. This line is simply the line chart that is plotted 26 periods behind. This is where Hosoda introduced the concept of cycle. The idea is that if both the lagging line and the market are in an uptrend at the time, then the current up move has better odds of continuing. The opposite is true for a declining lagging line and a down move. The bright blue line in “Trend signs” is the lagging line. In this example, however, the weekly EUR/USD moved opposite of the lagging line and this suggests the pair should reverse its uptrend.
The two leading lines, or senkou, create a cloud-like formation, or kumo in Japanese. The cloud is an area of support or resistance that varies in strength. The market must break above the cloud to give a buy signal or below the cloud to give a sell signal. The leading lines are used in a similar manner as standard support and resistance levels. However, the cloud extends well past the last trading period, providing a window into the future.
The formulas for the cloud’s leading lines are as follows:
Leading line A = (Trend line + signal line) / 2, plotted 26 periods ahead
Leading line B = (Highest high + lowest low) / 2 for the past 52 periods, plotted 26 days ahead
The cloud is highlighted in “Trade pattern” (below). In the medium-term, the pair was overbought in one instance (the red arrow) and oversold in two instances (the blue arrows). In all three instances, the euro reconverged toward the cloud. As always is the case with overbought and oversold conditions, traders should not sell or buy before the change of direction is confirmed. This is because markets overstretch. Despite the strength of the trends, the euro turned to consolidation while penetrating the cloud.
As you can see, the cloud has different levels of thickness. Generally, a thick cloud signals good support or resistance and increased volatility. Conversely, a thin cloud suggests a period of low volatility and indicates an upcoming sideways market.
Relative strength signals
In addition to the intersection between the currency price and one or two of the individual lines, in sync moves and overbought/oversold conditions, the Ichimoku method also provides trading signals called relative-strength signals.
For instance, a bullish crossover that occurs above the cloud formation provides a strong buying signal, and a bearish crossover formed below the cloud indicates a bearish signal. If the crossover occurs within the cloud, then the buy or sell signals are normal in significance. In addition, a bullish crossover turns into a weak buy signal if formed below the cloud formation. Conversely, a bearish intersection loses technical significance if it occurs above the kumo.
In “Weak ones” (below), we can see examples of relative strength signals on the daily EUR/JPY chart. The red arrow indicates a weak sell signal above the cloud and the blue arrow points to a weak buy signal.
The Ichimoku works best on the daily and weekly chart, just like all other technical studies. However, it can be used on intraday charts — if used carefully. In “Short-term Ichimoku” (below), the EUR/USD penetrated the support of the cloud at point A and there was no looking back. It attempted a recovery, but the move was capped by the cloud at point B. Backing the down move were the declining trend and signal lines.
The Ichimoku formulas use durations of nine, 26 and 52 periods. These figures were not chosen randomly or by optimization. When Hosoda developed this method, a trading week was six days. He based his parameters on one and a half business weeks (nine days), one business month (26 days), and two business months (52 days), respectively.
Since then, however, the trading week has been reduced to five days. This suggests that the parameters should be adjusted to seven, 22, and 44. Applying the indicator with these inputs is a ripe area for study. In addition to accurate parameters, traders reasonably could expect the signals to be more timely than those using the original parameters.
Cornelius Luca is president of LGR at www.LucaFXTA.com. He is the author of “Trading in the Global Currency Markets” (Penguin Books, 3rd. ed., 2007); “Technical Analysis Applications” (McGraw-Hill, 2004); “Technical Analysis Applications in the Global Currency Markets” (Penguin Books, 2nd ed., 2000) and “Introduction to Technical Analysis” (Euromoney, 1997).