Firstly, I want to say thanks to Tim for letting guests post. I think it is a wonderful idea and will bring a myriad of viewpoints from around the globe (literally).
So, about a week ago, I read some chatter in the comments from thunda72 (the guy with the sweet avatar) and wycfitz about Ichimoku clouds.
At first they look confusing … just a bunch of seemingly random lines. However, when used properly, Ichimoku clouds can help confirm or deny an ongoing trend. Keep in mind, it would not be a good idea to use this indicator/strategy alone in your trading decisions. This indicator is not the best for signaling tops and bottoms. What it is good for, is finding resistance/support zones and trend information. In this post, I will discuss how the Ichimoku cloud can be used, and show how a simple indicator can be designed to rate long/short signals with strength.
Here is the Ichimoku cloud on the daily SPX chart (Ichimoku comes as a study with TOS). The default input values are 9 for the Tenkan period and 26 for the Kijun period (Ichimoku(9, 26)). The Ichimoku cloud can be used on any time frame. The Tenkan line is the cyan line and the Kijun line is the fuchsia line. These are the lines we want to watch for a signal. We consider a bullish crossover when the Tenkan line crosses above the Kijun line, and a bearish crossover when the Kijun line crosses above the Tenkan line (referred to as the K/T cross).
The cloud is composed of the two orange and red span lines which are pushed forward in time. This cloud can act as a zone of resistance or support. Instead of normally treating resistance/support as a single price level or line, the cloud gives resistance/support a thickness which reduces the risk of a false breakout. The general theory is, price action above the cloud indicates we are in a bullish trend while price action below the cloud indicates a bearish trend. The Chikou is the gray line which is basically the current bar's close moved back 26 periods ago. Note that the colors in your TOS setup may be different, but I chose these to help distinguish which line is which. For a complete definition of how each line is defined, check http://www.fxwords.com/u/ichimoku-cloud.html.
After reading the literature that is out there on Ichimoku clouds, there is a general method of determining signal and strength from this indicator as follows:
- The signal is 0 (neutral) at all times unless a K/T crossover occurs.
- First, determine whether the K/T crossover is bullish or bearish. Do this by determining whether the Kijun crossed above the Tenkan, or vice-versa. Positive points will be given in the bullish scenario while negative points will be given in a bearish scenario (+1 for a bullish K/T cross, -1 for a bearish K/T cross).
- Determine where the K/T cross occurred with respect to the cloud.
-In a bullish scenario, a strong signal is achieved when the K/T cross occurs above the cloud (medium signal within the cloud, and weak signal below the cloud).
-In a bearish scenario, a strong signal is achieved when the K/T cross occurs below the cloud (medium signal within the cloud, and weak signal above the cloud).
- Where is the price action with respect to the cloud?
-In a bullish scenario, price action above the cloud will strengthen the bullish signal.
-In a bearish scenario, price action below the cloud will strengthen the bearish signal.
- Where is the Chikou with respect to the cloud?
-In a bullish scenario, the Chikou above the cloud will strengthen the bullish signal.
-In a bearish scenario, the Chikou below the cloud will strengthen the bearish signal.
Following the flow chart above, you can see that a signal starts out as either a +1 or -1. The signal becomes strengthened by further criteria: where the K/T cross occurred, where the price action is, and where the Chikou is. What you end up with is a bullish signal ranging in strength from +1 to +5 (-1 to -5 for a bearish signal). I whipped up a little TOS script which basically uses the source code from the Ichimoku indicator and builds a signal strength indicator. To spare some of you a lot of explanation, I won't go through the details of how to write the thinkscript code to do so, but I'd like to in a future post. You can import this into TOS as a study and it will be called IchimokuStrength. Download IchimokuStrengthSTUDY.
Remember, don't use this signal as a signal to initiate long/short positions. Use it as a supplemental indicator that helps confirm an ongoing trend.