When I started to observe how most new traders use and understand indicators I was very surprised to see that few people knew what indicators were about and most called them “failures” due to the fact that they simply didn’t understand how to use them correctly. This is exactly why I decided to create the “indicator series” of posts which – through the past two years – has helped traders better understand what indicators are truly about (what their mathematical basis is) and how the true meaning of indicators can be interpreted to design algorithmic trading strategies. Success in the use of indicators depends simply on your level of understanding about what the indicator is truly telling you. On today’s post I will talk about an indicator which few people seem to really understand or use correctly, this indicator – the Ichimoku Kinko Hyo – is actually a wonderful tool which easily shows us a dimension of price action which is not easily seen through naked charts.
The Ichimoku Kinko Hyo indicator was developed by Goichi Hosoda in the 1930s in a quest to show traders a better way to describe the information present on price charts. The indicator was in fact named the “one glance balance chart” due to the fact that it attempted to condense a large amount of information which could be accessed at one simple “glance” of the indicator’s chart. The indicator is traditionally formed by 4 lines which are used to describe the position of different levels which are considered to be relative support and resistance levels, the interaction of these levels with price and how they position themselves relative to one another give us a very powerful tool which can certainly be used successfully in the creation of algorithmic trading strategies.
The line of the Ichimoku Kinko Kyo are called the Tenkan-sen, Kijun-sen, Senkou Span A and Senkou Span B. The Tenkan-sen is simply the average of the highest and lowest price for the past 9 periods while the Kijun-sen is the average of the highest and lowest price levels of the past 26 period. The Senkou Span A is the average of the first two lines and the Senkou Span B is the average of the highest and lowest price levels of the past 52 periods. As you can see the indicator is merely based on a notion of “range centers” or “median points”. The Ichimoku uses the short term, medium term, average short-mediun term and long term median points as references which can help us better understand what is going on when we trade.
Perhaps the most interesting part of Ichimoku is the fact that Senkou Span A and B are drawn 26 periods into the future while the other lines are only drawn up to the current bar. This projection into the future does not imply that the indicator has some “glimpse” of the future but it is merely an artifact created to emphasize the connection between the average short-medium term median and the long term median in determining levels which might be relevant going forward. For example when the average short-medium term median is higher than the long term median it means that in the short and medium term price has been trading across a higher absolute range, implying that the “box range” in the medium and short term is above or in the upper portion of the “long term box”.
Another very interesting fact here is that the distance between Senkou Span A and B is a proxy for volatility as whenever the distance between the two medians grows larger there is an inherent faster movement in the short-medium term relative to the long term range. Indeed Ichimoku has its own implicit measurement of volatility which could obviously be expanded through a plotting of the difference between both bands. You could then build an Ichimoku Volatility indicator which you could also use as an aid (position sizing and target measurement) when building alrogithmic Ichimoku trading strategies. Such an indicator calculating volatility over a daily Ichimoku would be quite useful.
Ichimoku can also be traded in a very wide variety of ways when we take into account the meaning of median interactions. For example we could use Ichimoky as a way to follow trends considering where price stands relative to the “kumo” (the above mentioned range between Senkou Span A and B). When price is inside the last kumo span and then it goes out towards one side we could trade a breakout until price moves above the shifted kumo and then into it again. The above image shows you how this would be executed on a EUR/USD chart. This way of trading makes sense because we’re merely trading when we breakout of the short-median term high (in this case as it is an up trend) and we exit whenever we move above and then back below this median. It is in fact a very simple trend following strategy based on the position of price relative to a median value.
You can also use the simple relative size of the Kumo in order to trade. For example you can enter trades whenever the Kumo expands to a certain value and then only exit trades when the Kumo re-expands but with an inverted order in the Senkou Span lines. This simply means that we wait for a significant momentum to build up (significant difference between short-medium term and long term average medians) and we only exit when we see similar momentum being built onto an opposite moving trade. This is a strategy which can be used for the capturing of long term trends as you do not exit trends just because of minor retracements (small buildups of momentum to the opposite side). The size threshold of the Kumo can be defined as a given percentage according to the past X period average of its size.
The are undoubtedly a ton more ways in which the Ichimoku set of lines can be used to derive useful algorithmic trading strategies but certainly the above mentioned suggestions serve as a good introduction into how to understand and properly use this indicator. As with all strategies we need to consider the fundamental mathematic base of the indicator and build an understanding regarding what these calculations mean about price action. Of course testing would be needed to know to what extent the above suggestions could be successful but they hint at the possible rational uses of Ichimoku based on its mathematical origin.
If you would like to learn more about the building of algorithmic trading strategies and how you too can use indicators after truly understanding them please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)