Finding Big Money Breakouts with Our Favorite Indicator: The Ichimoku Cloud
What is the Ichimoku Cloud?
The Ichimoku Cloud is a technical indicator I first encountered while traveling through Asia in 2006. Talking shop with other traders I had met on my travels, I quickly realized that this ‘Cloud’ they kept referring to was different from any other indicator I had ever used. I was also surprised at how simple and intuitive the Cloud was to use. While it may look confusing at first, the Ichimoku Cloud is actually one of the simplest indicators to use. Before we can approach the actual applications of the Cloud, let’s discuss what the Cloud actually is.
The Ichimoku Cloud is a technical analysis method that uses sets of moving averages to produce key levels in the past, present, and future. The Cloud helps traders identify at a single glance if a security or other financial product is trading in bullish or bearish territory. Ichimoku Kinko Hyo literally translates to ‘One Glance Equilibrium Chart’ because it can be used for analysis using only a glance. For this reason, the Cloud is one of the most efficient technical indicators available.
The Cloud is made up of 6 key components, each of which we will examine individually. When these 6 components are combined, they form the Ichimoku Cloud. Below is an image of the Apple Inc. (AAPL) on a daily chart with the Cloud. We can use the Cloud to identify key levels of support and resistance, determine trend, and determine the strength of the trend.
As can be seen below, the Cloud is actually a forward-looking indicator. The Cloud is projected 26 periods forward, so the levels under the current price were formed 26 days ago. The Cloud is unique in that is uses both past data and forward-looking levels. Since the levels are forward looking they tend to be more reliable than simple moving averages. The lagging indicator component also provides confirmation of breakouts by looking 26 periods back to determine if a stock is likely to break through levels. It is this concept of looking at the past, present and future that makes the Cloud so valuable. In the next section we will look at the individual components of the Cloud and how they are calculated
Calculating the Components of the Cloud
The Tenken-Sen Line: Short term trend line similar to a 10 period moving average. It is known as the turning line and is a signal of a region of minor support or resistance. This component is calculated by taking midpoint between the highest high and the lowest low over the past 9 periods.
The Kinjun-Sen Line: Known as the confirmation line. This component also serves as a signal for support and resistance levels. Many traders use this line as a level for a trailing stop. It also serves as an indicator of trend. If price is above the Kinjun-Sen Line then the stock is in bullish territory, likewise if it is below the line it is in bearish territory. This line is calculated by taking the midpoint between the highest high and the lowest low over the past 26 periods.
Senkou Span A: This line forms one of the boundaries of the ‘Cloud.’ If the stock is trading above the line then the line will serve as a major support level. If price is below this line it will serve as a level of major resistance. This component is calculated by taking the average of the Tenkan-Sen and Kinjun-Sen lines. This line is unique in that the results of this calculation are plotted 26 periods ahead. This means that today’s Senkou Span A line was actually plotted 26 days ago.
Senkou Span B: This line forms the other boundary of the ‘Cloud.’ This line serves as a second level of support or resistance and is calculated by taking the midpoint between the highest high and the lowest low over the past 52 periods. Like the Senkou Span A line, this is also plotted 26 periods ahead. This line is similar to a 50% Fibonacci retracement.
Kumo: This is the shaded area, located between the Senkou Span A and Senkou Span B lines, that is used to form ‘the Cloud’ itself.
Chinkou Span Line: This line is also known as the lagging indicator. This line is the current bar’s closing price plotted 26 periods back. The lagging indicator is often used as confirmation of signals and can also serve as a support and resistance level. The lagging indicator can also assist a trader in confirming the direction and strength of trends.
Why Use the Cloud?
With so many indicators included in charting packages, why should a trader focus on only one indicator? The Cloud is unique in the fact that it has current, past and future components that can be used as key levels, and can project potential future price action. Although this is the main reason I love the Cloud so much, there are other important reasons as well.
One of the best things about the Cloud is that not very many people know how to use it. Everyone uses Bollinger bands and moving averages but the Cloud is used far less in practice. Why is this good you might ask? In the age of algorithmic trading, many high-frequency trading firms will try and run the stops of weaker traders. They target levels based on where they believe people will have stops in place. Since people tend to put stops in at levels derived from other, more common studies, it is easier for the high-frequency trader to take them out. If a trader uses the Cloud to set stops and targets, it is not likely there are a lot of other traders at those same levels. This means that stops won’t be targeted as much as they would if a trader used more popular studies.
The flexibility of the Ichimoku Cloud is also one of its greatest qualities. The Cloud is applicable to any product on any time frame. This means that any trader can use the Cloud effectively. The Cloud can be used for trading stock, options, futures, and currencies. All of the products will have a time frame that they work best on, but the Cloud can be used to trade any of them. Later on we will discuss what time frames work best for what asset classes.
Trading Options with The Cloud
I have been trading equity options for the past 12 years. While I often trade stock and other products like currencies and futures, I still consider equity options to be my bread and butter. When on the trading floor I didn’t use charts. I would focus all of my attention on order flow and implied volatility. After I left the floor and moved upstairs I realized that my trading plan would benefit from an addition of technical analysis. The Ichimoku Cloud has proven itself to be the most effective technical indicator I can use as an options trader. Here we will discuss how I apply the Cloud to my proprietary trading plans and why it works so well.
As an options trader, I base the vast majority of my trades on what I call ‘unusual option activity.’ Unusual option activity is a large block trade that takes place at a multiple above the average daily option volume in a specific stock. These unusually large trades are placed by large institutional market participants and can represent the flow of the ‘smart’ money in the options market. Simply put if I see big institutional players betting heavily on upside or downside in a specific stock, I try and follow that trade.
The key to trading unusual option activity is being able to infer what, if anything, the institutional trader’s underlying stock position might be. Remember that the majority of options market participants are hedgers. This means that orders cannot always be taken at face value. If I see a large put buyer it’s possible they are hedging a large long stock position rather than trying to get short. Likewise, when I see calls being bought, it is possible the trader is hedging a short stock position rather than trying to get long. Determining if a bet is speculative or a hedge is my number one goal when trading unusual option activity, and the Ichimoku Cloud helps me do this.
The Cloud is an excellent indicator of trend and the strength of the trend, so when I am trying to determine the motives behind a large block trade, I see the Cloud as being extremely helpful. If the Cloud is indicating a strong bullish trend in a stock that I see puts being bought in, it is much more likely the institutional trader is hedging a long stock position. When I’m trying to determine if a trade is speculation or a hedge, I need to perform my analysis very quickly, in a matter of seconds. The Cloud helps with this as well. Thousands of trades hit the tape in any given day so I am constantly looking at charts of stocks I am seeing action in.
Being able to determine if a stock is in bullish or bearish territory at a single glance is essential to being able to analyze stocks very quickly. Using the Cloud for trading unusual options activity really boils down to a single concept: if institutional traders are buying puts in a stock above the Cloud, I do not want to get short. Alternatively, if they are buying calls in a stock below the Cloud, I do not want to get long.
Using the Cloud to weed out all of the false signals and traps has greatly increased the profitability of my trading plan. The Cloud helps guide me into the best possible set ups. While I’ve given only a handful of examples of how I apply the Cloud to my trading plan, I truly believe the Cloud is versatile enough to work for anyone.
Using the Cloud to Trade Stocks: When using the Ichimoku Cloud to trade stock, one of the most important considerations I must make is deciding what time frame I must use. Generally, I believe stock trades best with the Cloud on the daily chart. This is not to say intraday equity traders cannot still use the Cloud successfully. However, it will produce more traps when used on tighter time frames.
The Cloud for the Day Trader: Using the Cloud on an intraday basis can show a trader where intraday levels of support and resistance are. A day trader can also use the Cloud to find the highest probability setups.
The Cloud for the swing trader: Using the Cloud can help the swing trader avoid trading against trends and can help steer them away from stocks that are in neutral territory. Using the Cloud can also point them to stocks that are near breakout points.
The Cloud for the long-term trader: Using Cloud pullbacks can point out opportunities to enter or add to positions. The long-term trader can use the Cloud to determine when it is time to exit a position. Since the Cloud is forward looking, the Cloud can also give a heads up before trend might turn the other way.
No matter which of the above categories you might fall into, you will be able to benefit from using the Cloud. As a trader I mostly fall mostly into the first two categories. Most of my stock trades are either day trades or swing trades. Using a shorter time frame may change the way I use the Cloud but the basic concepts stay the same. I use the support and resistance levels the Cloud provides as levels for stops or profit targets. The Cloud also tells me when I should enter or exit a trade. Look at the image below and take note how the Cloud provides me with my entry and a level to place a trailing stop.
Look at this older setup in AAPL:
These same levels can be used on any time frame. The chart above is showing AAPL stock on a daily chart, but I would be looking for the same things on a 15, 5, or even 1-minute chart. The time frame I’m using can also depend on the product I am trading. Some securities trade much faster than others and require a shorter time period chart. Likewise, some securities are slower and produce too many traps on a lower time frame chart. In the next section, we will discuss how to determine the best ways to use the Cloud no matter what product you are trading.
The Best Way to Use the Cloud
The setup described above can be used to trade breakouts in any product on any time frame but a trader must understand which time frames they should be using for each individual product type. As we have explained previously, the Cloud is one of the most versatile technical indicators available. Its applications are wide and as long as a trader realizes what the best uses are for the Cloud they can easily apply it to their trading plan. Even though the Cloud can be used for trading any security it is not a ‘one size fits all,’ indicator. If used on a less than optimal time frame for a specific product, the Cloud can produce many traps. A trader must always consider what they are trading and how fast that security tends to trade. Below we will explain the use of the Cloud in several of the more popular products traders trade.
Stocks- The best signals come from the daily chart. Using the daily chart will provide the best setups for swing traders and longer-term players. Stocks can still be day traded using the Cloud, but on an intraday time frame, using anything faster than a 15-minute chart will produce many traps.
Currencies and Currency Futures - Trade best on a 4-hour bar. Currencies trade very well on the Cloud but as with equities, the Cloud produces the best signals on a longer time frame. The Cloud can be used for intraday trading of currencies but using anything faster than a 15-minute chart will have the potential to produce many traps.
Crude Oil Futures- Trade very fast. When trading crude oil futures or any other fast moving product we can still use the Cloud on shorter time frames. A trader can use a chart as fast as the 5-minute bar and still be effective with the Cloud.
Treasury Futures- Treasury Futures often trend well intraday. A trader can use the Cloud very well when trading these. Time frame depends on the specific product being traded. In general, products that tend to trend rather than sit in a range are the best products to trade on the Cloud.
There are several considerations a trader must make when using the Cloud. The Cloud can be used on any product, but in general we want to focus on trending products. Keep in mind that one security might trade differently on a different time frame, and we must always consider this when using the Cloud.
Look at the short side breakout example below:
SUMMARY
We always say that there are no shortcuts in this game. There is no such thing as a sure thing. All we hope for is a way to increase our chances of success. After more than a decade of trading experience I have learned exactly what tools I am able to make the most of and which strategies and resources don’t work for me. When I say the Ichimoku Cloud is my hands-down, most favorite technical indicator I am not joking. I’ve been using it for years and regret having not discovered it earlier in my career. It is one of the most versatile tools a trader can have access to and its ease of use and overall accessibility make it a great resource for traders of all skill levels.