The Ichimoku Kinko Hyo, or equilibrium chart, isolates higher probability trades in the forex market. It is new to the mainstream, but has been rising in popularity among novice and experienced traders. Known for its applications in futures and equities, the Ichimoku shows more data points, which provide a more reliable price action. The application offers multiple tests and combines three indicators into one chart, allowing a trader to make the most informed decision. Learn how the Ichimoku works and how it can be applied to a trading strategy.
Getting to Know the Ichimoku Chart
A basic understanding of the components that make up the equilibrium chart need to be established before a trader can execute effectively on the chart. The Ichimoku was created and revealed in 1968 in a manner unlike most other technical indicators and chart applications. While applications were usually formulated by statisticians or mathematicians in the industry, the indicator was constructed by a Tokyo newspaper writer named Goichi Hosoda and a handful of assistants running multiple calculations. This indicator is now used by many Japanese trading rooms because it offers multiple tests on the price action, creating higher probability trades. Although many traders are intimidated by the abundance of lines drawn when the chart is actually applied, the components can be easily translated into more commonly accepted indicators.
The application is made up of four major components and offers the trader key insights into FX market price action. First, we'll take a look at the Tenkan and Kijun Sens lines. The lines are used as a moving average crossover and can be applied as simple translations of the 20- and 50-day moving averages, although with slightly different timeframes.
1. The Tenkan Sen: calculated as the sum of the highest high and the lowest low divided by two. The Tenkan is calculated over the previous seven-to-eight time periods.
2. The Kijun Sen: calculated as the sum of the highest high and the lowest low divided by two. Although the calculation is similar, the Kijun takes the past 22 time periods into account.
What the trader will want to do here is use the crossover to initiate the position – similar to a moving average crossover. 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 downtrending 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:
3. Senkou Span A: the sum of the Tenkan Sen and the Kijun Sen divided by two. The calculation is then plotted 26 time periods ahead of the current price action.
4. Senkou Span B: the sum of the highest high and the lowest low divided by two. This calculation is taken over the past 52 time periods and is plotted 26 periods ahead.
Once plotted on the chart, the area between the two lines is referred to as the Kumo, or cloud. Comparatively thicker than typical support and resistance lines, the cloud offers the trader a thorough filter. The thicker cloud will tend to take the volatility of the currency markets into account instead of giving the trader a visually thin price level for support and resistance. A break through the cloud and a subsequent move above or below it will suggest a better and more probable trade. Let's take a look at the comparison in Figure 2.
Taking our USD/CAD example, we see a comparable difference between the two currencies. Although we see a clear support at 1.1522 in our 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. The cloud suggests a better trade opportunity on a break of the 1.1450 figure by taking the volatility and apparent take back into account. 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
The last piece of the Ichimoku is the Chikou Span. Seen as simple market sentiment, the Chikou is calculated using the most recent closing price and is plotted 22 periods behind the price action. 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 attractive 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 the Ichimoku Chart All Together
There's no better substitute for learning how to trade the Ichimoku chart than application. Let's break down the best method of trading the Ichimoku cloud technique.
Figure 5 – Lines that tell a complete story
Trading the Ichimoku Cloud
Taking our U.S. dollar/Japanese yen example in Figure 4, the scenario in Figure 5 will focus on the currency pair fluctuating in a range between 116 and 119 figures. 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 above, these two indicators act as a moving average crossover, with the Tenkan representing a short-term moving average and the Kijun acting as the baseline. 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. 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.
We will want to see a close of the session below the cloud before initiating any type of short sell position because we are equating the cloud to a support/resistance barrier. 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 can now either 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 require a minimum of a 1:1 risk/reward ratio with a preferable 2:1 risk/reward for legitimate opportunities. In our example, we will maintain a 2:1 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 2:1 risk to reward – a profitable opportunity.
One key note to remember: notice how the Ichimoku is applied to longer timeframes, as this instance shows daily figures. The application will not work as well with many technical indicators since the volatility is in shorter timeframes.
To Recap the Ichimoku Chart:
1. Refer to the Kijun/Tenkan Cross. The potential crossover in both lines will act in a similar fashion to the moving average crossover. This technical occurrence is great for isolating moves in the price action.
2. Confirm Down/Uptrend With Chikou. The probability of the trade will increase by confirming that the market sentiment is in line with the crossover, as it acts in similar fashion with a momentum oscillator.
3. 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.
4. Follow Sound Money Management When Placing Entries. The trader will be able to balance risk/reward ratios and control the position by adhering to strict money management rules.
The Bottom Line
The Ichimoku chart indicator is intimidating at first, but once broken down, every trader will find the application helpful. The chart meshes three indicators into one and offers a filtered approach to the price action for the currency trader. Additionally, this approach will not only increase the probability of the trade in the FX markets, but assist in isolating the true momentum plays. The Ichimoku provides an alternative to riskier trades, where the position has a chance of trading back former profits.