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Trading with Clouds

Trading with Clouds

The Art of Ichimoku
By James Stanley Trading Coach DailyFX EDU instructor@dailyfx.com

This information is provided to you for educational purposes only. This article does not suggest that you will experience similar profitable trades as the ones illustrated. Currency trading involves significant risk of loss.

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Origins

The fact that I can be trading at my home in Dallas, TX where I can see, interpret, and act on the same signal that a trader from Shanghai, or Sydney had also identified - plays directly to the self-fulfilling prophecy of Technical Analysis. Its almost as if its a language that, once learned, can whisper potential trade ideas in the traders ear. However in practice traders will often learn that the benefits of Technical Analysis arent in the secret messages, that may or may not exist in markets; but the fact that it can help point to potential opportunities. Many traders find a combination of indicators that they feel really strongly about; spend hours upon hours practicing, and manually back-testing (testing the way that the strategy would have worked on charts that had already taken place) to ensure they can get the advantage they are looking for. Even then principals of trade, risk, and money management are of the upmost importance. Most traders will find that negligence in any of these elements is akin to stuffing your money down a garbage disposal, even if trading with a strong technical strategy. A system that has recently gained popularity in the United States - and has the pizzazz, of potential for being a self-fulfilling prophecy; while at the same time offering a strong technical infrastructure rooted on sound fundamental trading theory is Ichimoku (pronounced Each-E-Mo-Ku). Ichimoku is a trading system that was originally developed by Japanese journalist Goichi Hosada as he was looking to develop The Ultimate Indicator, that could provide a multitude of analysis with a very quick glance. As a matter of fact, the term Ichimoku, literally means one glance, in Japanese. Ichimoku is considered to be a self-contained system in the fact that no additional indicators are necessary everything is included that most traders will need to make trading decisions. Ichimoku is widely traded and followed throughout Japanese trading rooms lending many to the idea that the unique ways of identifying support and resistance can make the system more compelling for Yen pairs such as GBP/JPY, EUR/JPY, and USD/JPY. There are quite a few components of Ichimoku and it can make a chart look quite busy. Lets start learning about this indicator by going right for the core of what makes Ichimoku tick.

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Trigger the Base-Line At the very center of Ichimoku are the Tenkan-Sen and Kijun-Sen lines (referred hereon-out as Tenkan and Kijun respectively.) These two lines are the center of the Ichimoku system and can be looked at as the trigger, that denotes bullishness or bearishness. Tenkan and Kijun are really just moving averages. They differ slightly from standard moving averages in that they consider the Average price, of each candle versus only the closing price (such as a simple or exponential moving average generally will). This causes the line to appear jagged (as opposed to the smoothing effect of a Moving Average calculated on close.) Tenkan is commonly the first input that the trader sees when applying Ichimoku to a chart. This is a 9 period Moving Average, and we can consider this the TRIGGER LINE of the system as this is where all of the action behind Ichimoku is taking place. I make this line Lime Green when applying Ichimoku so that it stands out and is very clear when a crossover takes place. Kijun is commonly the second input that is used and this is a 26 period Moving Average (also exponential, calculated on average price). We can consider this as the BASE LINE.

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When the trigger line crosses up and over the base line this can be considered a bullish signal.

When the trigger crosses down, and through the base line this can be looked at as a bearish signal.

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The rest of the indicators within Ichimoku can help by telling us the strength, which each crossover signal can be interpreted with. For right now it is important to become familiar with the Trigger/Base Line Crossover. If youre not comfortable with this crossover yet, lets apply it on the chart and manually back-test a few trades to get comfortable with the way that this works. While learning the Trigger/Base Line crossover, it may help to arrange the Ichimoku indicator in an easy-to-read manner so that crossover is very clearly printed on the chart. For the remainder of this article, I will be using a Green, line for Tenkan, and a Blue, line for Kijun. Once completed, our charts should look roughly similar to what you see below:

Now that we have Ichimoku completely applied to our charts we can notice the power of the Trigger Line/Base Line crossover.

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While getting started with this system lets ignore everything on the chart other than the Trigger and the Base Line. We can manually back-test this crossover very simplistically on the Trading Station 2/Marketscope platform. Scroll back in time by clicking and dragging to a previous period on the chart. Marketscope will automatically pull data from FXCM servers to fill in the appropriate pricing data. After youve gone far enough back, you can hit the lock view, button on the toolbar (picture below). This will allow the chart to stay on the time period you scrolled to when a new candle forms (rather than auto-scrolling to the new candle).

Now that we are back in time we can begin testing the Trigger Line/Base Line crossover. We can do this by simply clicking on the Forward-Arrow, on our keyboards. This will cause Marketscope to go forward one candle at a time on the chart. We can keep going forward until we see a Trigger Line/Base Line Crossover. Each time a crossover takes place make note (either by writing down, or just noting mentally) and go further forward in time watching how a hypothetical signal would have played out.

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For example notice on the below chart that we have a Bullish Crossover taking place on on GBP/JPY. Ive highlighted the portion of the chart in which the Trigger Line is crossing over the Base Line indicating the bullishness that may be entering into the pair.

We can then go forward in time by clicking on the Forward-Arrow, of the keyboard watching the way that this hypothetical BUY would have worked out.

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After testing the way that this BUY entry would have played out we see that the Bullish crossover of the Trigger Line over the Base Line immediately preceded a 1,000+ pip run on the GBP/JPY currency pair. We can then move onto the next crossover which if you look at the chart above will notice that the bearish crossover (Trigger Line fell down, and through the Base Line) took place shortly after the high around 162.50 was hit. We can now chart this SELL to see the way that it would have hypothetically worked out.

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In the chart below Ive highlighted this SELL as the Trigger Line has crossed down and through the Base Line. Notice that this entry would not have been as profitable as the previous bullish entry that we had taken but after the signal took place GBP/JPY went down over 700 pips.

The goal of manually back-testing these entries is so that we can internalize what happens when the Trigger Line crosses the Base Line. These are two of the most important elements of Ichimoku and are the very core of the system. Everything else in Ichimoku can help us interpret these BUY and SELL signals indicating how strong they may be. Manually back-test until you feel comfortable with the Trigger Line/Base Line crossover, and comfort with this signal is of the upmost importance when trading Ichimoku. If you have a difficult time remembering which line is which, try to think of it as Tenkan = Trigger, and Base Line = Blue.

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The Cloud 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. Its one of the areas of this indicator that makes the field of study so interesting. Its constantly changing in area and in width. Kumo actually just consists of two lines. The area in between the two lines is shaded and its 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. By default Marketscope will print Kumo as BLUE during up-trending markets.

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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).

One of the more unique aspects about Kumo is that its built for 26 periods in advance. If you observe current price on any chart in Marketscope 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.

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How to Interpret Kumo Now that we know what Kumo is lets 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 its location in regards to Kumo and grade the strength of the signal accordingly. Lets 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. Lets walk through each of the signals to see the way that traders would generally interpret these crossovers.

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

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.

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

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

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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.

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 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.

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How to Use Signal Strength Now that we know how to integrate Kumo when we receive a Trigger/Base crossover, lets 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 involves trade size. 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 for the Trigger/Base Line Crossover. Scrolling back in time on Marketscope; and then moving forward one candle at a time to observe the way that the currency pair traded after receiving each of the signals outlined above.

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The Filter Now that we know how to incorporate Kumo, into our Trigger/Base Line crossover, lets take a look at the last component of Ichimoku. The Filter, as I call it - can work similarly to Kumo, in that it can help us determine how strong, the signal taking place from the Trigger/Base crossover is. Chinkou-Span (referred here-on-out as The Filter,) is just current price plotted 26 periods ago. Thats it. No scientific calculations, or complicated mathematics required its just an iteration of current price plotted 26 periods late. The value of The Filter, is in showing where current price action is in relation to where price action was 26 periods ago. If price of the current candle is higher than price was 26 periods ago, that is generally looked at as BULLISH (price is higher than 26 periods ago).

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If price of the current candle is lower than price 26 periods ago, that is generally looked at as BEARISH (price is lower than 26 periods ago).

Lets walk through a couple of examples to see how traders are using The Filter, with Ichimoku trading signals.

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In the example below, notice that a BULLISH Crossover has just taken place ABOVE Kumo.

If you remember from the last lesson we learned that this is a LONG signal that traders would generally interpret as strong, due to the AGREEMENT between the crossover and the location of price with respect to Kumo. Now that we can incorporate The Filter, into the strategy, we can observe that this long signal is potentially even stronger that we may have initially thought confirmed by the fact that The Filter, is above price action 26 periods ago. This indicates that the trend may be very strong to the upside and potentially conducive for LONG positions. Traders could interpret this signal, as extremely strong, as there is now Kumo, and Filter confirmation of our BULLISH signal. The exact opposite would be the case for SHORT positions. BEARISH Crosses of Trigger/Base BELOW Kumo are made even stronger with confirmation of The Filter, being below price action 26 periods ago.

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Lets look at an example where The Filter, could potentially keep us from entering into positions we may not want. In the chart below, notice that there are 2 Trigger/Base Crossovers taking place ABOVE Kumo.

Observe the first signal which would have been a BEARISH Signal as the Trigger has crossed DOWN and UNDER the Base Line. This takes place ABOVE Kumo, and The Filter, is also ABOVE Kumo both indicating BULLISHNESS. The BEARISH signal we have just received DISAGREES with the BULLISHNESS we are seeing on both Kumo, and The Filter. And, as you can see from the chart choosing to go short here wouldnt have worked out too well.

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However, if you notice Signal 2 taking place shortly after, you will see that we have a BULLISH cross as the Trigger crosses UP and OVER the Base Line.

On Signal 2 we have AGREEMENT: The BULLISH Crossover agrees with the BULLISH state of Kumo (price is ABOVE Kumo), and The Filter, residing above Price Action at the time of the signal. Traders would consider this LONG BUY signal to be extremely strong, as there is AGREEMENT between the signal, Kumo, and The Filter.

Because The Filter, is built 26 periods behind current price, manually back-testing this part of the indicator can be challenging. However, one mannerism that traders often use to become more familiar with The Filter, is forward-test on demo accounts; setting the size of the lot traded based on how strong the signal was.

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For example on BULLISH Crossovers: Below Kumo & The Filter BELOW price 26 periods ago Weak Signal (1 Lot) Crossover taking place between Kumo, Filter in Kumo Moderate Signal (2 Lots) Above Kumo & The Filter, is above price 26 periods ago Very Strong (3 Lots) On BEARISH Crossovers: Above Kumo & The Filter, ABOVE price 26 periods ago Weak signal (1 Lot) Crossover taking place in Kumo/Filter in Kumo Moderate Signal (2 Lots) Below Kumo & The Filter, Below Kumo Very Strong (3 Lots)

Setting Risk with Ichimoku Up until now, weve focused primarily on the entering into positions based on Ichimoku but we havent yet talked about the part of trading many traders consider to be even more important than the entry. And that is the management of risk. This aspect of the indicator is a little more open to interpretation, as traders can customize methods of managing their trades based on their own individual needs. In this section, well look at mannerisms for setting risk based on Ichimoku. Decide how aggressive you want to be The first thing that a trader needs to decide when using Ichimoku is how aggressive they would like to be with the signals that are generated from the Trigger/Base Line Crossover. If a trader wanted to be very aggressive, they could take every crossover that is generated regardless of signal strength. These traders could base the trade size on the strength of the signal just as we had walked through in the previous section.

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For example on BULLISH Crossovers: Below Kumo & The Filter BELOW price 26 periods ago Weak Signal (1 Lot) Crossover taking place between Kumo, Filter in Kumo Moderate Signal (2 Lots) Above Kumo & The Filter, is above price 26 periods ago Strong Signal (3 Lots) On BEARISH Crossovers: Above Kumo & The Filter, ABOVE price 26 periods ago Weak signal (1 Lot) Crossover taking place in Kumo/Filter in Kumo Moderate Signal (2 Lots) Below Kumo & The Filter, Below Kumo Strong Signal (3 Lots)

Traders that are more conservative, or choosy with their signals, may choose to take only the extremely strong, signals. This way they are only entering into LONG Positions when price is ABOVE Kumo, and The Filter, is above price 26 periods ago. SHORT positions are only being opened when price is BELOW Kumo, and The Filter, is BELOW price 26 periods ago. Lets walk through a few examples together.

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On the chart below, youll notice 3 Trigger/Base crossovers all outlined with red circles. Lets go through each of these in the order they took place.

Signal 1 takes place as the Trigger Crosses up and OVER the Base line. This crossover takes place ABOVE Kumo. Traders will generally interpret this as bullish, and observing The Filter, at the time would have showed the trader that The Filter, reading was higher than price 26 periods ago and this would be an extremely strong signal. Aggressive traders taking all signals generated by Ichimoku might decide to place a trade for 3 lots to account for the strength, of this extremely strong, signal. More conservative traders that were only going to take the extremely strong, signals may look to enter a trade to go long for 1 lot. Signal 2 is a BEARISH signal as the Trigger crosses DOWN and UNDER the Base Line. This takes place ABOVE Kumo. Remember traders generally look for AGREEMENT between the signal and where price is in relation to Kumo. Aggressive traders may look to place a trade to go short for 1 lot as they want to act on ALL signals generated by Ichimoku. Conservative traders may prefer to not act and wait until a stronger signal is generated. Signal 3 is a BULLISH crossover that takes place inside of Kumo. Traders will generally consider this to be a signal of moderate strength.

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Aggressive traders may look to place a trade for 2 lots to account for the moderate strength behind the crossover. Conservative traders may look to another currency pair, or perhaps continue waiting until a more decisive signal was generated.

Setting stops with Ichimoku Once a position is opened, there are multiple ways of setting stops with Ichimoku. First I would like to point out that sound principals of money, risk, and account management are always suggested regardless of what system you may be trading. If you are unfamiliar with money management, we present an entire module with nearly 1 hour of On-Demand Videos on the topic within the DailyFX+ Trading Course. This is available to ALL Live clients of FXCM (accessible directly by clicking on the link below). DailyFX+ Trading Course The area of the Ichimoku indicator that is chosen for stop placement is largely going to be dependent on how aggressive traders would like to manage their positions. Traders choosing to be aggressive, will generally look to place tighter, stops on their trades; whereas conservative, traders generally try to allow more wiggle room, for their trades. Additionally, weak, signals that are generated present a different set of options over strong, and extremely strong, signals. Lets look at a few options below.

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Weak Signals As you can see from the chart below, weak signals offer the fewest possible points of interest for settings stops as we do not have the luxury of Kumo. However, traders can look to 2 common areas to set their risk on the trade.

For traders looking to trade with a tight stop, they can set the stop of their long position on the Base Line. Traders preferring to be more conservative, allowing the trade more room (and potentially a larger loss if signal is incorrect) could set their stops at the most recent swing high or swing low. Its important to remember if a Trigger/Base Line Crossover generates an opposing signal the previous signal is no longer valid. Ichimoku is either BULLISH or BEARISH at any point in time but never both at the same time.

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Strong Signals

Strong signals bring the luxury of being able to utilize Kumo for the setting of stops. You may notice that the width of Kumo will continually expand and contract. Kumo can be looked at as a moving area of support and/or resistance and can help incorporate volatility into our trades. When Kumo expands and gets wider that is accounting for increased volatility. When Kumo contracts and gets more narrow that indicates decreased volatility. Notice on the chart below, the various areas that can be looked to for setting of stops.

Just as we had in the weak, signal the Base Line offers a tight stop on the position. The risk with this stop is that shorter-term noise, can potentially take us out of the trade.

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Traders in the long position above can also look to Kumo using any area within the range of Kumo. Traders can set the top line of Kumo as their stop or if wanting more room for the position to wiggle, the bottom line of Kumo.

Managing Trades via Ichimoku

Its important to note at any one point in time Ichimoku is BULLISH or BEARISH depending on the location of the Trigger and Base Lines. If the Trigger Line is higher than the Base Line this is BULLISH and traders would generally want to be in LONG BUY positions. If the Trigger Line is below the Base Line this is bearish and traders would want to be in SHORT SELL positions. If we are in a LONG BUY position, and the Trigger line crosses down and under the Base Line that could be looked at as a potential closing signal. If we are in a SHORT SELL position and the Trigger line climbs up and over the Base Line once again, we can look at that as a potential closing signal. Lets go over a couple of the more common methods of managing trades via Ichimoku.

Manually Trailing the Stop Trailing a stop would be moving the stop further in the direction of the trade (higher if in a LONG BUY position, lower if in a SHORT SELL position) as the position moved in our favor. The goal of which is to lock up profit, so that if the position begins moving against us we have profit built-in, to our stop. The most common way of managing a trade via Ichimoku is manually moving the stop. As the position goes further into potential profit, we can continue to ratchet our stop (higher for LONG BUYS, lower for SHORT SELLS) with the goal of locking up more of the gain in the position.

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Automatically Trailing Stop Traders on FXCMs platforms have the options of using trailing stops that will automatically adjust without any additional input from the trader needed. Traders can choose to trail, their stop. With this option, traders can choose to trail, their initial stop. As the position moves into the traders favor, the stop will automatically be adjusted based on that traders preferences.

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Now that you know the basics of trading with this fascinating indicator, join us for our weekly Ichimoku, report on DailyFX.Com, as well as the weekly Live Session that is available to all live clients of FXCM as part of DailyFX+. In the DailyFX+ Trading Course, we offer live webinars 3-4 times per day in the Trading Room. DailyFX+ Live Trading Room

Each Tuesday, I host a Strategy Session that is available for any live account holder of FXCM. To login to the DailyFX+ Trading Room, you can navigate to DailyFX+, login, and click on the link for Trading Course. To be notified of upcoming events for Ichimoku, including the weekly Ichimoku Report as well as Live Webinar Sessions, please email Instructor@DailyFX.com, with Ichimoku as the subject line.

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