Trading with Clouds

By | October 18, 2014

Drive Wealth

As if investing was not complicated enough, any mention of ‘technical analysis’ is likely to cause most individual investors to roll their eyes and ask “What now?” Fear not. You’re set to learn one of the easiest and yet most powerful approaches to market analysis that may help improve your investing and maybe even give you peace of mind.

Technical Analysis (TA), for those unfamiliar with the term, is an approach to market analysis that focuses on price movements. Well-intentioned people can reasonably debate about what the proper value of a share of Google or Coca Cola should be, or what the right value of gold is.

One issue they can’t dispute is what the price of Google, Coke, or gold is now or what it’s been in the past. That’s where technical analysis comes in. Technical Analysis takes the subjectivity (and emotion) out of the picture and zeroes in on the one component of an investment that we can all see: the price.

There are literally hundreds of different approaches to technical analysis, with thousands of books and articles having been written about them. The approach we introduce below is known as Ichimoku, a form of a moving average system. Ichimoku (ee-Chee-Mo-koo) charts offer a powerful tool for investors to identify overall market trends and pinpoint key levels of support and resistance that are unlikely to be revealed by other forms of technical analysis.

Don’t be scared off by the name—that’s where the simplicity comes in. Developed in Japan, Ichimoku (full name Ichimoku Kinko Hyo) roughly translates into “one glance cloud chart.” Ichimoku has a strong following in Asian circles, especially in Japan where it originated, and has become increasingly popular among global traders and investors.

The real beauty of Ichimoku is the speed and ease with which trends, trend changes, and significant price levels (support and resistance) can be identified, making it an easy addition to any investor’s repertoire of analysis. Ichimoku is a long-term, trend following system, making it ideal for long-term investors and is best analyzed in daily and weekly timeframes.

First, let’s take a look at an Ichimoku, or ‘cloud,’ chart to see what it looks like and what the key components are. We’ll introduce both the Japanese name and an Americanized name to correspond with the charts shown.

Cloud 1

A daily Ichimoku chart of the S&P 500. Note how well the various Ichimoku lines supported the recent move higher and are now potentially signaling a directional shift lower.

Source: Bloomberg, DriveWealth

There are five lines on an Ichimoku chart (typically overlaid on a candlestick price chart):

  • Tenkan line/Conversion line (purple)—the faster moving average
  • Kijun line/Base line (yellow)—the slower moving average
  • Senkou span A/leading span 1 (orange)—average of Tenkan/Kijun lines projected into the future
  • Senkou span B/leading span 2 (green)—average of high/low of past 52 days projected into the future
  • Chikou/lagging span (gray)—today’s closing price projected 26 days into the past

The space between the two Senkou/leading spans forms the cloud (blue), or ‘kumo’ in Japanese. The cloud represents a zone of support or resistance, and its thickness indicates the strength of the support or resistance zone.

 

How to interpret an Ichimoku or Cloud chart

Now that you know what a ‘cloud’ chart looks like, what are you supposed to do with it as an investor? Here’s where the simplicity of the cloud comes into play. It only takes a few minutes a day (or a week or   a month) to get a better picture of how your investments are faring and potentially adjust your investing strategy. All based on objective price data.

The first element to note is ‘where is the price relative to the cloud?’ If price is above the cloud, then it’s considered an uptrend. If price is below the cloud, then a downtrend is likely in place. If inside the cloud, then the security or index is consolidating or moving sideways and a trend-change may be developing.

Trend changes (longer-term shifts in price movements) can easily be identified based on movements of the price relative to the cloud. From an investing standpoint, prices above the cloud suggest a buy-and-hold strategy may be warranted. A price shift down below the cloud bottom may indicate a more conservative investing stance may be justified, or that long portfolios might be trimmed back for a period. If you’re looking to add to existing long portfolio positions, a price move below the cloud may also be viewed as a signal that better buying levels may be ahead.

The two moving average lines (Tenkan & Kijun) can be important leading indicators, signaling a potential trend change before the cloud comes into play. Both lines act as support and resistance on their own, potentially suggesting price levels where profits might be taken (selling a rally or a bounce) or fresh investments might be made (buying on a correction or price decline).

In particular, the Kijun line frequently serves as an important trend-entry level. For instance, a particular security may be in an uptrend (above the cloud), but the move higher may be pausing. If prices drop back to the Kijun line, it may be a good opportunity to enter or add to existing positions in line with the major trend higher.

When the Tenkan and Kijun lines cross, directional signals are generated that may alert you to larger prices shifts ahead that may be helpful to your overall investing strategy. If they cross to the upside (Tenkan moves above Kijun), it may serve as an early indication that a low-point may have been reached and that higher prices may be ahead. If they cross to the downside (Tenkan moves below Kijun), then recent price gains may be topping out and even reversing lower.

The lagging span (Chikou) serves to double-check the scenario indicated by the other lines. If price is above the cloud (bullish), and the Tenkan has crossed or is above the Kijun line (bullish), and the Chikou span is above the price, it strengthens the bullish outlook. If the Chikou span is below the price while the other lines are suggesting a more bullish scenario, it may only be a temporary rebound.

Ichimoku charts provide a powerful and relatively simple way to gauge a market’s directional trend and identify key support and resistance levels. Trading signals are generated by crossovers of the main ichimoku lines and breaks of the cloud. Traders can also use Ichimoku charts to anticipate possible future price developments based on the location of the cloud. Whether investing in individual stocks or wider indexes and ETFs, investors should strongly consider adding Ichimoku to their regular routine of market research.

 

Brian Dolan

Head of Financial Education

DriveWealth, LLC

7 thoughts on “Trading with Clouds

  1. kharthik

    For indian market do you have any ideas whose provide cloud chart

  2. SP Iyengar

    Thanks for giving an understandable introduction and for the article published.You are really taking your followers to higher levels….thanks again for your good work..

  3. Equity Bull

    I have learnt Ichimoku and it works very very well..

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