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Trading with Clouds

Trading with Clouds
The Art of Ichimoku
By James Stanley
Trading Coach
DailyFX EDU


“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. It’s almost as if it’s a
language that, once learned, can whisper potential trade ideas in the trader’s ear.
However – in practice – traders will often learn that the benefits of Technical Analysis
aren’t 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. Let’s 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 you’re 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 – let’s 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 you’ve 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. I’ve 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 – I’ve 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. 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. 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 it’s 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 – 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 its 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.

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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,
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 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,
let’s 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. That’s it. No scientific calculations, or complicated mathematics required –
it’s 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).

Let’s 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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Let’s 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 wouldn’t 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, we’ve focused primarily on the entering into positions based on Ichimoku
– but we haven’t 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, we’ll 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.
Let’s walk through a few examples together.

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On the chart below, you’ll notice 3 Trigger/Base crossovers – all outlined with red
circles. Let’s 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. Let’s look at a few options below.

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