Ichimoku Kinko Hyo, a trend-following system frequently applied by Japanese technical analysts, was relatively unknown in the Western world until recent decades due to the absence of an English translation of how to use the indicator. In this guide, we'll explain how you can take advantage of this trading system to identify profitable opportunities with a high probability.
What is Ichimoku Kinko Hyo?
Ichimoku Kinko Hyo (also known as Ichimoku) is a charting system that was developed in Japan by a journalist named Goichi Hosoda. Hosoda released his system to the public in 1968 after he enlisted a group of students to run simulations by hand and test the system for twenty years. As a trend-following system, Ichimoku provides an outlook of the trend, its momentum, and areas of potential support and resistance.
The translation of Ichimoku Kinko Hyo is ‘equilibrium chart at a glance’ which comes from the fact that the system informs us whether the price of an asset is in equilibrium from a quick look at the charts. Since the market is made up of human traders, it reflects group behaviour and just as you cannot stay happy or angry forever, the market also returns to its equilibrium.
The indicator can be daunting at first because there are so many components, but we’ll break these down one by one and explain how to trade cryptocurrency using the Ichimoku system.
How to Use the Ichimoku System in Your Trading
The Ichimoku indicator is composed of four main parts; the Tenkan Sen (or conversion line), the Kijun Sen (or base line), Chikou Span (or lagging line), and the Kumo (or the cloud) which is created by Senkou span A and Senkou span B.
These four components must be analysed with respect to the market price to get a full understanding of what is happening in the market. Let’s start with the cloud as understanding this is key to trading with the Ichimoku indicator.
The Kumo (Cloud)
The main part of the Ichimoku system is the Kumo or cloud, which is the equilibrium zone for an asset’s price. The cloud is created by the Senkou span A and Senkou span B, where:
Senkou span A = (conversion line + base line)/2, then shifted forward in time 26 periods, and
Senkou span B = (high + low)/ 2, where the 52-period high and low are used and then shifted forward 26 periods.
The cloud's colour will be green or red depending on the trend. In an uptrend, the cloud will be green, whereas in a downtrend, the cloud will be red. When the Ichimoku cloud changes colour, it is known as a 'Kumo twist' and provides an early indication of a trend change.
Since it is made up of the Senkou spans, the Kumo is also projected forward 26 periods to provide zones of support or resistance for future trading sessions.
Another entry signal is given when the price closes above or below the cloud. If the price has been contained within the Ichimoku cloud, then it suggests a breakout is imminent but we do not know the direction until the breakout actually occurs:
- When the price closes above the cloud, it suggests that an uptrend is beginning to form, and
- When the price closes below the cloud, it suggests a downtrend will follow.
When the price closes above or below the cloud, it is known as a Kumo breakout (displayed below).
After a Kumo breakout, we should look for the price to re-test the support or resistance zone and enter a position in the direction of the breakout. For example, after the Kumo breakout to the upside in the chart above, the cloud provided support numerous times, provided multiple entry signals to enter a long position.
Kumo as Dynamic Support and Resistance
The cloud also provides dynamic zones of support and resistance. The thicker the cloud is, the heavier the support or resistance zone.
On the other hand, an unusually thin cloud signals very weak support/resistance and we should look for a Kumo breakout.
For instance, the chart above shows that the price easily moved through the thin portion of the cloud. If we spot an unusually thin part of the Kumo, we should anticipate a price movement through this zone. The thicker part of the cloud provided strong resistance, while the price broke through the thin parts of the cloud. Whenever you spot a thin part of the Kumo, be ready to take a trade based on a break of this support/resistance zone.
While the Kumo provides dynamic zones of support and resistance for when the price is above/below the cloud, we can also think of each Senkou span as a support or resistance level when the price is within the cloud. Therefore, the price often bounces between the edges of the Kumo, known as a edge to edge trade (illustrated below). Typically, when the price enters the Kumo, it will be drawn to the other side (which is especially true if one of the Senkou spans has a long horizontal portion).
Finally, the direction that the cloud is moving tells us the momentum of a trend. For instance, if the cloud is ascending higher, it tells us that a strong bullish trend is in place. On the other hand, if the cloud descends lower, it warns us that a bearish trend is present.
Tenkan Sen (Conversion Line)
The Tenkan Sen = (high + low)/2, for the past 9 periods and shows short-term equilibrium.
The Tenkan Sen (or conversion line) trends in the market's direction and captures the market’s equilibrium better than a moving average as it includes the highs and lows rather than just the closing price. While the conversion line is usually a good indicator of momentum, given its short-term nature it is not as reliable as other components of the Ichimoku system on its own.
When the conversion line is flat, it tells us that the market has exhibited no trend for the past 9 periods. When the conversion line isn't flat, the angle of the line shows the momentum over the past 9 periods. Therefore, a rising conversion line suggests upward momentum is in play while a falling conversion line illustrates downward momentum.
If the price is below the conversion line, then it should act as a resistance level, while if the price trades above the conversion line, then it should provide support. Therefore, we can use the conversion line as a stop level to exit failed trades.
When the price crosses the Tenkan Sen, it is usually a good sign that momentum is shifting:
- A close above the Tenkan Sen when both the price and Tenkan Sen are above the cloud is considered a strong bullish signal.
- However, if both the price and Tenkan Sen are below the cloud, and the price closes below it, then this is considered as a strong bearish signal.
As shown in the chart below, the conversion line should always be close to the price. For instance, in the rally in April and June, the conversion line closely followed the market price and shows that the trend is developing without volatility interfering. However, if the price drifts away from the conversion line too far, there is a good chance the price will return to the conversion line and be pulled back into equilibrium.
How do we determine what is classified as “far” away from the base/conversion line?
If the price is more than 1.5 times the Average True Range away from the base line (or conversion line), then we should expect the price to return to this level of short-term equilibrium.
If during a trend, the price moves in the opposite direction of the trend and crosses the Tenkan Sen it could indicate one of three things:
- Minor, short-term pullback where the price crosses the conversion line but does not cross the base line. This usually occurs when short-term trades take profits, but long-term traders keep their positions open.
- Major short-term pullback where the price crosses both the conversion line and base line in the opposite direction of the trend. Eventually, the price continues in the direction of trend and crosses back over both the base line and the conversion line.
- Countertrend, similar to a major short-term pullback, but the price never cross the base line and conversion line again. Either the price consolidates or a new trend forms.
Kijun Sen (Base Line)
The Kijun Sen = (high + low)/2, for the past 26 periods and indicates medium-term equilibrium.
The Kijun Sen works similarly to the Tenkan Sen, but over a longer time period. Since the base line covers 26 periods (versus the conversion line’s 9 periods), it is more accurate at determining momentum and areas of support and resistance. The price respects the base line more and when it is flat, it attracts the price, giving rise to the ‘rubber band effect’.
However, the Kijun Sen will not give signals early on in a trend. Since this part of the Ichimoku system is based on the past 26 periods, it will take a while for a trend to establish itself.
As with the Tenkan Sen, we want to see the base line pointing in the same direction as the trend where the angle of the conversion line displays how much momentum is behind the move.
When price crosses the base line it provides a signal, where the price closing above the base line is a signal of bullish momentum. The price closing below the base line is a signal of bearish momentum.
One of the most reliable signals given by the Ichimoku system is the crossover of the Tenkan Sen and Kijun Sen, which can be thought of as similar to a moving average crossover. Since the Tenkan Sen is faster than the Kijun Sen, the Tenkan Sen will often move above or below the Kijun.
When the Tenkan crosses above the Kijun, it is an indication of bullish momentum.
When the Tenkan crosses below the Kijun, it is an indication of bearish momentum.
An example of the Tenkan Sen-Kijun Sen crossover is shown above for ETH-USD.
The cross-overs must also be evaluated against the cloud. If there is an upward cross-over while the price is below the cloud, then it provides a weak buy signal. If there is an upward cross-over while the price is above the cloud, then that is a strong buy signal. While a weak buy signal has more potential for profit, it is riskier and the strong buy signal has a lower profit potential but has a higher likelihood of success.
Chikou Span (Lagging Line)
Chikou Span = current price shifted back 26 periods.
The main purpose of the Chikou Span (or lagging line) is to confirm a trend:
- If the lagging line moves above the cloud, a bullish trend is confirmed.
- If the lagging line moves below the cloud, a bearish trend is confirmed.
The lagging line also provides support and resistance levels, with peaks and troughs formed by the closing price of trading sessions in the past. The daily chart for bitcoin shows that the trough of the lagging line in May 2019 provided a support level for the price in November 2019. We can also use the peaks as potential resistance levels.
We can also compare the Chikou Span with the previous price action. If the Chikou Span is above previous price action, then it suggests the market is bullish. However, if the Chikou Span moves from above to below the previous price action, then it gives a bearish signal.
If the Chikou span is in an open space, then the momentum behind a trend is strong as there is no resistance or support from the previous price action standing in the way. To judge momentum, look at whether the Chikou span will run into the price action in both the horizontal and vertical directions.
Putting it All Together
If you are new to the Ichimoku indicator, you should be aware that it is easier to use and provides more reliable signals on longer timeframes. Start with the daily timeframe and once you have mastered the Ichimoku system, then apply to shorter timeframes such as the 4-hour chart or 15-minute chart.
It is also important to keep in mind that you evaluate each of the components to form an integrated picture. That means you note of what the cloud is doing, what the Tenkan Sen and Kijun Sen suggest, whether the lagging line is bullish and bearish and evaluate them all against the price action.
The chart below shows the various signals given by the Ichimoku indicator for BTC-USD on the daily timeframe. The Ichimoku gave a few bullish signals in February, with the price and lagging line moving above the cloud and motivating a long position.
The Tenkan Sen and Kijun Sen were very close to the price and provided support as the cloud changed colour from red to green. Therefore, following the Kumo breakout to the upside and the lagging line confirming an uptrend, we could buy at the support levels provided by the Tenkan Sen and Kijun Sen.
Once in a long position, we would want to see the conversion line and base line trend higher. Also, we want to see higher highs in the lagging line and any time it establishes a peak, to draw a line and hold on to the long if the price action breaks this high. For example, in April, the lagging line formed a peak that was broken shortly after, which implies a continuation of the uptrend.
Also, notice that the cloud trended higher as the market rallied but eventually flattened out and changed colour after the peak in the price near $14,000. The price also leapt away from the base line near the peak, suggesting the market was out of medium-term equilibrium and signalled a return to the base line.
Finally, the price did not manage to move above the peak in the lagging line at $12,889 and on the second peak near $12,500, we should have noticed that momentum was slowing down as the cloud was flattening. Without a break of the resistance provided by the lagging line at $12,889, the upward trend lost steam and the price began to reverse and tend towards the long-term equilibrium zone indicated by the Kumo.
The drawback of using the Ichimoku as a trading strategy is that it is difficult to get your head around at first but with practice it becomes easier to interpret and apply. It is also worth mentioning that the Ichimoku system was designed for trading stocks and commodities (which only trade five days of the week). Therefore, it is common amongst cryptocurrency traders to increase the settings of the Ichimoku to (20, 60, 120, 30) instead of the default (9, 26, 52, 26), as cryptocurrency trades 24/7, 7 days a week.
By combining the Ichimoku with volume, you can get a richer outlook of the market you are analysing. You should also perform some back-testing to ensure that the Ichimoku signals you use are profitable for the instrument you are trading, which can be done on TradingView.