Trading with the Cloud – Use Ichimoku Cloud to Spot Reversals
The Western approach to technical analysis was taken by surprise when Japanese candlestick techniques that forecasted future prices were revealed for the first time. It as something so new and in the same time something so powerful, that the approach was quickly embraced by traders. We will discuss later the Japanese candlestick techniques as there should be no Forex Trading Academy without them. However, besides the candlesticks, the Japanese came with something even more mysterious, yet extremely powerful: The Ichimoku Kinko Hyo system.The reason I am referring to it as a “system” is due to its complexity. In reality, Forex brokers are listing the Ichimoku under the indicators list. Because it is formed out of multiple elements, some Forex brokers are looking at it as being a trend indicator, while others as being an oscillator. For the same of technical analysis, it doesn’t really matter as long as its interpretation is the correct one. If we are considering the very definition of a trend indicator, namely it is an indicator that is applied on the actual chart, then this should be one. The Ichimoku Kinko Hyo rough translation means “state of equilibrium” as the entire system formed by its elements shows exactly this: a state of equilibrium current price has relative to both past and future projected prices. Sounds fancy and complicated, but in reality, it is not like that. Being offered together with other indicators, it is applied exactly the same: just click the Insert/Indicators/Trend, and there the Ichimoku Kinko Hyo appears. To be noted here that the MetaTrader 4 it is listing the indicator as a trend indicator.
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By selecting the indicator, a pop-up window appears and one can set up its own color for all the elements, as well as the periods to be used. It is recommended that the standard periods should be left as they are, namely 9, 26 and 52. You will see later why the 26 period especially is really important when trading with the Ichimoku indicator.
Spotting Reversals with the Ichimoku Cloud
Before looking at how do we actually can spot a reversal with the Ichimoku cloud, it is time to list the elements of this complex indicator. The overall Ichimoku Kinko Hyo, or the whole state of equilibrium as mentioned above, consists of five elements: the cloud (or the “Kumo”), the Tenkan and Kinjun lines, and the Chinkou line. One may argue here saying that there are only four elements instead of five, but in reality the cloud it is being given by two averages that cross one another. These two lines are being called Senkou A and Senkou B and what’s in between represents the actual cloud. Therefore, five elements form the whole Ichimoku Kinko Hyo system.
Defining the State of Equilibrium
Price is the cornerstone of the Ichimoku indicator, as everything is built around it. To be honest, this is what an indicator should be focused on anyway: current price and what would be the future levels to be projected further in time. When compared with the current price, the cloud it is being projected twenty-six periods ahead and shows potential support and resistance levels. Therefore, if the indicator is attached to a monthly chart, then a trader will actually see the cloud projected for the next twenty-six periods or the next twenty-six months in this case. Moreover, the Chinkou line is projected twenty-six periods back in time, so, in conclusion, the current price is at an equilibrium when compared to both historical and future prices.
Spotting Reversals with the Cloud
The cloud comes in two colors that can be edited and it is either a bullish or a bearish cloud. A bullish cloud starts forming after a bearish trend, when Senkou A crosses above Senkou B, and usually it is represented with the color green. A bearish cloud forms after a bullish trend, when Senkou A crosses below the Senkou B line, and it is represented with the color red. On the MetaTrader 4 platform, the colors for the cloud are different, but you probably get the overall idea about how to interpret the cloud from the description above. What traders do in order to spot a reversal is, of course, to look for the cloud to turn during a strong trend. Therefore, in a bullish trend, if the cloud turns bearish, it is a sign that longs should be closed and we should short the market. The same is true when the cloud turns bullish after a bearish trend, as one should look to go long that market. One thing should be kept in mind all the time: the cloud forms twenty-six periods ahead of the current price! We can actually see it before price reaching there. This offers a competitive advantage ahead of the market and it gives a trader an educated guess about the future price action and if the cloud turns it means the previous trend is losing its strength.
Above is the EUR/USD four hours’ chart that has the Ichimoku indicator attached to it. As you can see here, the red cloud is bullish and the blue one is bearish.
Started from the left to the right, after a bearish trend, the cloud turns bullish and twenty- six periods earlier one can enter on the long side. Moving forward, the cloud turns bearish so twenty-six periods earlier one can short the pair all the way until the cloud turns bullish again. This is an ideal situation that is presented here, but overall it is working very well when trying to spot reversals on the Forex market. The fact that the cloud is so visible represents a strong warning for traders and this way it is not possible to end up on the wrong side of the market. One should keep in mind all the time that Forex trading means reacting to ever-changing market conditions and the Ichimoku cloud offers the possibility to know in advance what the future price action may bring. This is extremely important and represents a warning that conditions will change in the next twenty-six periods. Ignoring the cloud signal should be made on the trader’s own expense.
Other educational materials
- Overbought and Oversold Areas in Ranging Markets
- Profit from DeMarker Divergences
- Correlations Between Different Currency Pairs and Other Markets
- Leverage and Margin Requirements
- Forex Trading Platforms – Metatrader 4 and 5
- What is a Margin Call?
Recommended further readings
- Do Ichimoku Cloud Charts Work and Do They Work Better in Japan? Kai Jie Shawn L, Yanyali S, Savidge J. . International Federation of Technical Analysts Journal. 2016 Jul 9.
- Ichimoku Charts. Muranaka, K. (2000). TECHNICAL ANALYSIS OF STOCKS AND COMMODITIES-MAGAZINE EDITION-, 18(10), 22-31.