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Trading in the Clouds - The Art of Ichimoku, Part 2

Trading in the Clouds - The Art of Ichimoku, Part 2

2011-04-01 16:50:00
James Stanley, DailyFX Trading Coach,
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Trading in the Clouds – The Art of Ichimoku, Part 2

The part of Ichimoku that just absolutely jumps out at us when we apply it to our charts is the area known as ‘The Cloud,’ or called ‘Kumo,’ in Japanese. It’s one of the areas of this indicator that makes the field of study so interesting. It’s constantly changing – in area and in width.

Kumo actually just consists of two lines. The area in between the two lines is shaded and it’s considered to be a moving range of support during uptrends; and resistance during downtrends. Many traders will look to Kumo when setting stops on trades that were initiated by the Trigger/Base Line Crossover.

One of the more important tasks that Kumo can help traders with lies in its ability to denote the trend of the currency pair. When a pair is trending up, making higher highs and higher lows Kumo will function as support – sitting underneath price as the currency pair trades higher.

Trading in the Clouds - The Art of Ichimoku, Part 2

And when a pair is trending down, making lower highs and lower lows Kumo will function as resistance residing above price as the currency pair heads lower. These periods will show Kumo printed as RED on the chart by default (please see below).

Trading in the Clouds - The Art of Ichimoku, Part 2

One of the more unique aspects about Kumo is that it’s built for 26 periods in advance. If you observe current price on any chart while Ichimoku is applied you will notice that for 26 periods ahead – Kumo is already plotted and waiting for price. However – keep in mind that this has absolutely no forecasting value whatsoever.

Trading in the Clouds - The Art of Ichimoku, Part 2

How to Interpret Kumo

Now that we know what Kumo is – let’s discuss how traders are using it.

One of the more valuable functions of Kumo is its ability to show traders the potential ‘strength,’ of the Trigger/Base Line crossover. When this crossover occurs, traders will notice it’s location in regards to Kumo and grade the strength of the signal accordingly. Let’s walk through an example together.

On the GBP/USD chart below – there are 3 BULLISH crossovers taking place, all of which are circled in RED. Let’s walk through each of the signals to see the way that traders would generally interpret these crossovers.

Trading in the Clouds - The Art of Ichimoku, Part 2

During BULL CROSS 1 – notice that both price, and the BULLISH crossover are below Kumo.

Trading in the Clouds - The Art of Ichimoku, Part 2

When this crossover takes place, it is at the end of a downtrend that was previously bearish. Traders are unsure as to whether the trend is going to change to the upside; or if the bearish trend is going to prevail.

For this reason – traders will often consider this to be a weak signal. If the reversal does take place, the potential reward could be handsome; but reversals will not always take place. Observance of risk by setting a stop is extremely important for these signals.

During the BULL CROSS 2 – the crossover, and price are residing in Kumo as the Trigger crosses the Base Line.

Trading in the Clouds - The Art of Ichimoku, Part 2

Traders will generally consider these Trigger/Base crossovers taking place in between Kumo to be of ‘moderate,’ strength.

When BULL CROSS 3 takes place, with price and the Trigger/Base crossover residing above Kumo – Traders will generally look upon this signal as being ‘very strong.’

Trading in the Clouds - The Art of Ichimoku, Part 2

The reason that traders will generally consider BULL CROSS 3 to be strong is because of AGREEMENT. Remember, if price is above Kumo – traders look at the pair as being BULLISH. When the Trigger line crosses up and over the Base line (which is a bullish signal) AND price is above Kumo (a bullish environment) – Traders will enter into LONG positions considering the Trigger/Base Crossover Signal to be ‘very strong.’

The exact opposite is true for SHORT signals. BEARISH crossovers taking place below Kumo are generally considered to be ‘very strong,’ because – once again – we have that agreement. Pricing below Kumo indicates BEARISHNESS, and a BEARISH crossover will offer the agreement that a trader would want to consider the signal ‘very strong.’ BEARISH crossovers taking place ABOVE Kumo would be looked at as weak.

How to Use Signal Strength

Now that we know how to integrate Kumo when we receive a Trigger/Base crossover, let’s talk about one of the more popular ways that traders look to benefit from the ‘strength,’ of the signals produced by Ichimoku.

One very popular method of doing so involves the trade size that traders use.

When a weak signal is generated, traders can potentially look to open a position for 1 lot.

When a moderate signal is generated, traders can look to open a trade for 2 lots.

When ‘strong,’ signals take place traders can enter a position for 3 lots.

With this method – traders would be taking on larger trade sizes for signals that they felt were ‘stronger.’

Other traders may choose to take only the ‘very strong,’ signals that offer agreement (BULLISH crossovers ABOVE Kumo, or BEARISH crossovers BELOW Kumo).

Now that we know how to incorporate signal strength, we can manually back-test in the same manner we had done on the previous lesson. Scrolling back in time, and scrolling forward one candle at a time to observe the way that the currency pair traded after receiving each of the signals outlined above.

Next week we’ll talk about Chinkou Span and begin delving a little deeper into risk management while trading Ichimoku.

Next: Trading in the Clouds - The Art of Ichimoku, Part 3 (46 of 50)

Previous: Trading in the Clouds - The Art of Ichimoku, Part 1

If you’d like to be updated when the next Ichimoku article is available, please email us at Instructor@DailyFX.com and we’d be happy to keep you up to date.

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