Overview of the Ichimoku Method in Technical Analysis

If you are interested in taking your trading to the next level, having the Ichimoku method within your toolbox can. Ichimoku allows traders to thoroughly analyze charts faster. In fact, the name Ichimoku Kinkō Hyō means “one glance equilibrium chart” in Japanese.

Technical Analysis Background

Technical Analysis is a widely used but widely debated securities analysis methodology that predicts future stock movements by studying historical trends in price and volume [1]. While methods vary greatly amongst those who use technical analysis, the core principle remain the same: forecasting through analyzing chart patterns is based off of the use of moving averages, regressions, relative strength indexes, and market correlations. Ichimoku is one such method that enhances the traditional candlestick analysis used in charting to provide a more accurate forecast.

Technical Analysis vs Fundamental Analysis

Traders primarily use technical and fundamental analysis to predict the movement of any security. The primary difference between the two is technical analysis only examines price and volume while fundamental analysis examines the economics underlying a particular security such as earnings growth, dividends, current and new product development, industry competition, financial leverage, and macro trends [2]. In other words, one can perform technical analysis on any security without having any prior knowledge of the industry or products that produce the cash flows of the security. Many traders use a combination of technical and fundamental analysis, while some use technical or fundamental analysis exclusively when making trading decisions. Technical analysis is more popular amongst short term traders such as day traders, pit traders, and market makers.

Candlestick Analysis

The candlestick analysis is one of the oldest and most popular methods used by technical analysts. Candlestick trading strategies involves generating buy and sell orders by analyzing open, high, low and closing prices of a securities within a day or over consecutive days. Typically, traders who use candlestick analysis have a short term focus, holding their positions for 10 days or less [3]. Candlesticks are a graphical representation of a day’s open, high, low, and close prices. Candlesticks are composed of a body that shows the open and close prices and is represented by two different colors (black or white, red or blue) and a wick that represents the highs and lows of the day. If a security closed higher than it opened, then the body will be represented by a white or blue color and a black or red color if the security opened higher than it closed [4]. Candlesticks are great visual aids for deciding when investors are bullish or bearish for a particular security that day. For example, when the body is white or blue, it usually indicates investors are bullish for the day since the security closed higher than it opened. This means that there are more buyers than sellers, driving the closing price up.

Ichimoku Charts

Goichi Hosoda developed the Ichimoku Kink Hyo charts, or just Ichimoku for short. It is commonly used in Japanese trading floors. The method is commonly referred to as the Ichimoku cloud and is an indicator that shows support and resistance levels, identifies trend directions and momentum. It essentially uses moving averages using the middle of the range over some time period and shifts these lines in the future and past. The Ichimoku cloud is made of 4 key components [4]:
  1. The Tenkan Sen line (Conversion line): Average of the highest high and the lowest low calculated over the previous 7-8 time periods
  2. The Kijun Sen line (Base line) : Average of the highest high and the lowest low calculated over the past 2 time periods
  3. Senkou Span A line (Leading Span A line): The average of the Tenkan Sen and Kijun Sen lines plotted 26 time periods ahead of the current price action
  4. Senkou Span B line (Leading Span B line): The average of the highest high and the lowest low over the past 52 time periods plotted 26 time periods ahead of the current price action
Traders can shed a lot of information from the Tenkan Sen and Kijun Sen lines alone. These lines essentially represent moving averages of data points over a short and medium term period. When the two lines cross and more specifically when the Kijun Sen line crosses below the Tenkan Sen line, this means that near term prices are falling below the medium term trends and signals are downtrending price movement. The Ichimoku cloud shows even more detail and offers traders a visual filter. The general idea behind the Ichimoku cloud is that support/resistance lines should not be strict guidelines on deciding when to buy and sell. Since traders often place orders at varying distance from these resistance/support levels, it makes more sense to represent the lines as a general area. This way, the volatility of the markets is also taken into account. The area between the Senkou Span A and B lines forms the Ichimoku cloud. The basic theory behind the cloud is that if the price is above the cloud the overall trend is bullish, bearish if below the cloud, and indifferent if in the cloud. The top of the cloud will act as a guideline for a support level if the price is above the cloud and when the price is below, the base of the cloud will be a resistance level.

Summary

The Ichimoku Cloud is a powerful and advanced tool to help trader analysis trading signals and the strength of the support and resistance levels. By using a general area of support and resistance that are forward looking, traders can spot trends and reversals in advance so that they can take positions early.

Works Cited

[1] “Technical Analysis: Introduction” Investopedia. N.p., n.d. Web. 22 Jan 2013. [2] “Fundamental Analysis: Introduction.” Investopedia. N.p., n.d. Web. 22 Jan 2013. [3] Marshall, Benjamin. “ Candlestick Technical Trading Strategies: Can They Create Value for Investors?” (2005): 24-46 [4] Lashinski, Véronique Lashinski. “Ichimoku Kinko Hyo.” Journal of Technical Analysis 65 (2008): 42-49.