Last Updated on May 24, 2022 by Anjali Chourasiya
As traders, our goal is always to square up positions in the lush green – profits. But to bring this to reality, there’s a lot one needs to understand, assess and take care of. From trend analysis, reading the latest announcements from the company, fundamentals, financials, management changes to technical analysis, there is no dearth of assessment tools. One commonly used technical tool that helps with providing a comprehensive indication of levels is the Ichimoku Cloud. In this article, we dive deep into what the Ichimoku Cloud is and its components.
Table of Contents
What is the Ichimoku Cloud?
Ichimoku Cloud is a combination of several technical indicators that serve as a robust analysis tool. Goichi Hosoda, a Japanese journalist, came up with this indicator in the late 1960s. Ichimoku Cloud contains information about support and resistance levels, trend direction and momentum.
At first, Ichimoku Cloud might appear to be a bit difficult to understand, and that’s logical because it has so much to offer as a technical indicator. Modus operandi of Ichimoku cloud includes considering multiple averages and plotting them on a chart to predict the support and resistance zones.
Components of Ichimoku Cloud
We just learned the Ichimoku Cloud consists of multiple moving averages. To be precise, there are five of them. Let’s us know them in a bit detail:
Conversion Line (Tenkan-Sen)
Tenkan-Sen, moving average, is a red line on the chart. Tenkan-Sen is arrived at by taking the average of the high and the low achieved by the stock for the last nine periods.
When the Tenkan-Sen is moving up or down, it indicates the market is in a trend. However, if the Tenkan-Sen line moves horizontally, then it is an indicator of a range-bound market.
Formula: Tenkan sen = 9PH + 9PL / 2
PH = Period High
PL = Period Low
Base Line (Kijun-Sen)
Kijun-Sen is a blue coloured line that tells us about the expected price movements in the future. It is also known as the support resistance line. A blue line usually represents it. Contrasting to Tenkan-Sen, which considers nine periods, Kijun-Sen considers 26 periods, and thus, lags behind the Tenkan-Sen line.
Formula: Kijun sen = 26PH + 26PL / 2
Leading Span A (Senkou Span A)
Senkou Span is not a moving average in itself, but it is the average of Tenkan-Sen and Kijun-Sen’ highs and lows. On a chart, the Senkou span A is an orange coloured line.
It is pretty easy to interpret as when the price of the underlying security is higher than the Senkou span A (orange line); the top and the bottom lines act as the first and second support levels. However, when the security price is below the Senkou span A, the bottom and the top lines act as resistance levels.
Formula: Senkou span A = CL + BL / 2
BL = Base Line
CL = Conversion Line
Leading Span B (Senkou Span B)
Senkou Span B arrives when highs and lows of the past 52 periods are averaged out and plotting 26 points to the right.
Formula: Senkou span B = 52PH + 52PL / 2
Lagging Span (Chikou Span)
It is referred to as the Lagging Span, the reason being it is plotted 26 periods to the left, while all the other averages are plotted to the right. A green line represents the Chikou Span.
Formula: Chikou Span = Close plotted 26 periods in the past
Steps to calculate Ichimoku Cloud
When using the Ichimoku Cloud, all you need to do is apply the Ichimoku Cloud analysis to the security chart you are studying. Though if you are craving for some pen-paper calculations for a change and want to understand the working of Ichimoku Cloud, here’s a step-by-step guide to follow:
- Calculate the conversion line and the base line using the respective formulas given above.
- Using the two data points, you will be able to calculate Leading Span A, as it is an average of the two. Next up, you are required to plot this data point.
- Calculate Leading Span B, and just as you did in Leading Span A, plot it 26 periods into the future as well.
- After that, calculate the Lagging Span; remember to plot it 26 periods into the past on the chart, unlike the Leading Spans plotted in the future.
- Now, the difference between Leading Span A and Leading Span B creates a cloud, and this cloud is coloured for visual aid.
- Occasions when the Leading Span A line is above the Leading Span B, you can use green colour to colour the cloud. And when Leading Span A is trailing below the Leading Span B, colour the cloud in red.
- Join all the data points to each other, and you’ll observe lines and cloud formation.
Benefits of using Ichimoku Cloud
This technical indicator brings in bundles of information for you to implement as a trader; here’s what you’ll get at your disposal:
Information regarding trends: The overall trend is positive when the price is above the cloud and the underlying security is an uptrend. When the price is below the cloud so formed, the trend is negative and the security is going in a downtrend. However, when the price is within the cloud, there is no clear trend.
Confirmation of the trend: An uptrend is confirmed when the Leading Span A is above the Leading Span B, and the spacing between the two averages is coloured in green. On the contrary, Leading Span A falling below the Leading Span B confirms a downtrend, and the spacing in between the average lines is coloured in red.
Support and resistance levels for the future: One thing that sets Ichimoku Cloud apart from other technical indicators that dish out support and resistance levels is that Ichimoku Cloud reveals support and resistance levels for the future as well, and not just for the current date.
Limitations of Ichimoku Cloud
Just like every technical indicator out there, Ichimoku Cloud isn’t without certain visible shortcomings.
It is based on historical data: The fact that Ichimoku Cloud uses lagging data is a major turn-down for people seeking a more predictive approach. The Ichimoku Cloud uses historical data, and even though we expect history to repeat itself in the stock market, there’s no guarantee for it.
Overdose of information: Ichimoku Cloud is often criticized for presenting too much information on a single chart. This leads to a situation called paralysis by analysis, as there’s an increasing chance that a trader might get confused comprehending all the information. Though you can modify the indicator by removing the lines, you don’t need to.
False signals: The possibility that Ichimoku Cloud gives false signals about the support and resistance levels cannot be ruled out.
This one-of-its class indicator may be slightly difficult to interpret, but since it comprises five different averages, it can be expected to result in dependable signals. The indicator uniquely forms clouds with colour codes representing the trends. Traders with a viewpoint of low to medium term may capitalize the most of Ichimoku Cloud.