How to Use the Ichimoku Cloud Indicator - Perpetual Protocol 🥨

In this guide, we’ll show you how to use a popular trend-following trading system: the Ichimoku cloud indicator.

The Ichimoku Kinko Hyo is a trend-following trading system released by Japanese journalist Goichi Hosoda in the late 1960s, which means ‘equilibrium chart at a glance’. Western traders only started to understand this powerful technique in the 1990s after being properly translated into English.

There are four different components of the Ichimoku indicator that should be integrated to form a full picture of the price action, and after reading this article you should be able to understand the momentum and trend of a market just from a quick glance at the chart. We’ll go through each of these components one by one and detail how each part of this system works.

A key concept to understand when using the this indicator is that of equilibrium, borrowed from the field of chemistry which usually refers to a situation where the rates of forward and reverse reactions are equal. But in the context of the Ichimoku cloud, equilibrium refers to the situation when there’s a balance between buyers and sellers. When prices are out of equilibrium, this is where we can spot trading opportunities (as we’ll see later on in the article).

Go to ‘Indicators’ then search for ‘Ichimoku cloud’ to add this indicator to your chart when trading on on Perp v2:

Overview

The Base Line
The Conversion Line
The Lagging Line
The Cloud
Combining the Ichimoku’s Components: A Full Trading System
Summary

The Base Line

The base line (also known as the Kijun-sen) acts as an indicator of future price movement. It is calculated as:

(Highest High + Lowest Low)/ 2, for the past 26 periods.

The equation above shows that the base line is like a moving average, but it considers the midpoint of the highest and lowest prices for the past 26 periods (instead of tracking the average price).

There are four key things to know about the base line:

The base line helps to gauge the price momentum. If the price is above the base line, then recent price momentum has an upward bias. On the other hand, when the price is below the base, momentum is more geared towards the downside.
It also indicates the short-term trend, e.g., in uptrends the slope of the base line is positive, while for downtrends, the base line has a negative slope.
The base line can also be thought of as short-term equilibrium, providing support or resistance levels.
When price crosses the base line, then it provides a bullish signal when crossing above and a bearish signal when crossing below. These signals are known as the Kijun crosses.

Let’s look at an example to illustrate, abstracting from all other components of the Ichimoku cloud indicator.

The example for ETH-USD below shows how the base line indicates the trend and how Kijun crosses can be used as entry signals. In early April, the price of ETH closed below the base line, after which a downward trend was established. Once the base line flattened out, then it indicated that the downtrend was losing momentum and a reversal was confirmed, with the price closing back above the base line.

But as shown above, there are some fake signals. For example, during February and March, the base line was mostly flat, meaning there was no clear trend and you would've got chopped up if you had taken longs or shorts once the price closed above or below the base line.

During the downtrend, we can see that the base line provided resistance, while in uptrends it often acts as support. There’s also a tendency of the price to fluctuate around the base line when it has flattened out and suggests that there’s no short-term trend, which is known as the “rubber band effect” (shown by the price action in early March from the chart below).

The Conversion Line

The conversion line (also known as the Tenkan-sen) acts as an indicator of future price movement. It is calculated as:

(Highest High + Lowest Low)/ 2, for the past 9 periods.

Three of the four things we can learn from the base line also apply to the conversion line: so it provides another perspective of the short-term trend, momentum, areas of support and resistance. And instead of the Kijun cross, the conversion line has its own signal: the Tenkan cross.

As illustrated below, since the conversion line accounts for just the past 9 periods, it is faster than the base line and is quicker in highlighting the short-term trend. Similar to the base line, the conversion line also identifies the short-term trend, provides signals when the price closes above or below it (known as the Tenkan cross).

For example, we see a bullish Tenkan-cross at a price of around $2,800, with ETH-USD eventually reaching highs around $3,400. But in April, we saw a bearish Tenkan cross, where the price fell from $3,200 and entered a strong downtrend.

However, this means that if you only consider the conversion line in isolation, there’ll be more fakeouts, which underscores the importance of interpreting all of the components of the Ichimoku cloud indicator together.

The “Rubber Band Effect”

Similarly to the base line, when the conversion line flattens out, the price is often attracted to this zone, either finding support or resistance around this zone or fluctuating around it until a new short-term trend is established.

The chart above illustrates with an example. This is known as the “rubber band effect”, where the price is attracted towards the conversion line (or base line).

The (2.5*ATR) Rule of Thumb

When thinking about the conversion line as short-term equilibrium, that means the price will eventually return to this area. One rule of thumb is that whenever the price diverges too much from the conversion line (2.5 multiplied by the average true range), then it could be a good opportunity for a mean reversion play.

The chart below illustrates an example, when the low from June 13th was lower than the conversion line minus (2.5* ATR) = 1281.63. Since the low was beneath 1281.63, this gave us a sign that the downward move may be over-extended and the price is out of equilibrium, suggesting it will eventually return to the conversion line.

By June 18th, the closing price meant that the price was moving back within the following range: [conversion line - (2.5*ATR)], and eventually returned to the conversion line. Using this rule of thumb can help you spot when price advances or declines have become over-extended and when a reversal is likely to occur.

The Tenkan-Kijun Cross

Since the base and conversion lines are similar to moving averages, another signal given by the Ichimoku cloud indicator is when these lines crossover, which is like a golden cross/death cross for moving averages. This signal is known as the Tenkan-Kijun cross.

When the conversion line crosses above the base line, then it indicates momentum has switched from bearish to bullish.
When the base line crosses above the conversion line, it indicates that momentum has flipped from bullish to bearish.

Some examples are shown on the chart above.

The Lagging Line

The lagging line (also known as the Chikou span) is used to identify support and resistance.

The lagging line is calculated as:

The most recent period’s closing price, projected back 26 time periods on the chart.

There are two main things the lagging line tells us:

Whether the current price is above or below the price 26 periods ago
Levels of support and resistance

Since the lagging line shows the current price shifted back into the past, we can quickly see whether the current price is above or below the price 26 days ago. If the current price is higher, then it indicates that there is potential for more bullish price action.

On the other hand, when the current price is lower than the price 26 days ago, then it’s likely there’ll be bearish price action. An example of a bearish signal is shown below, when the price falls enough for the lagging line to go beneath the candle 26 trading sessions prior.

The troughs and peaks of the lagging line often offer important support and resistance levels worth paying attention to.

The Cloud

The cloud (also known as the ‘Kumo’) is the final component we’ll look at, which is composed of two lines known as the Senkou span A and Senkou span B.

Senkou span A is calculated as:

(Tenkan-sen + Kijun-sen)/2, plotted 26 periods ahead.

Senkou span B is calculated as:

(Highest High + Lowest Low)/2, for the past 52 periods, plotted 26 periods ahead.

Together they form the cloud or Kumo, which is very useful in determining how the price may evolve over time.

There are four main uses of the Kumo:

Identifying the long-term trend
Identifying support and resistance
Identifying breakouts with the Kumo breakout
Identifying trend changes with the Kumo twist

Identifying Long-term Trend

While the base and conversion lines identify the short-term trend, the cloud helps you to identify the long-term trend, depending on its colour and which way it is moving (up or down).

When the cloud is green and moving higher, then it signals a strong, long-term uptrend. On the other hand, when the cloud is red and moving lower, then it signals a strong, long-term downtrend.

It’s also important to consider the current price in relation to the cloud.

When the price is above the cloud, then it’s an uptrend and we should look for opportunities to go long.
When the price is below the cloud, then it’s a downtrend and we should look for opportunities to go short.
When price is within the cloud, the trend is neutral as the market is in long-term equilibrium. However, a breakout will occur eventually (the Kumo breakout).

Cloud as Support/Resistance

The advantage of the Ichimoku cloud indicator is that it displays dynamic zones of support and resistance, instead of horizontal lines, as with traditional support and resistance levels.

Also, the thickness of the cloud represents the strength of these support or resistance zones. So if the price is approaching the cloud, and it’s relatively wide, then the price is less likely to push through. However, whenever the cloud is relatively thin, then it highlights that support or resistance is very weak and the price is likely to move through this zone easily.

Two examples below illustrate this tendency for the cloud to offer stronger support when it is thicker and weaker support when it is thinner. A similar principle can be used for resistance levels too.

However, a thin cloud doesn’t always mean the price will just break though. If the price cannot break through a thin part of the cloud, then it suggests buyers or sellers are not strong enough to overcome even weak resistance or support.

The Kumo Breakout

The cloud itself represents long-term equilibrium and if the price is trading within the cloud, then it can become volatile and is likely to break out. The longer the price stays within the cloud, the higher the chances of a breakout and a new trend establishing itself.

For example, the chart below shows when the price closes below the cloud and how it signals a new downtrend. Notice that after spending some time trading at equilibrium inside the cloud, the price eventually broke out to the downside, with the Ichimoku cloud holding as resistance.

One technique to use when the price enters the cloud is the edge-to-edge signal, which basically says that you should long when the price moves into the cloud and short once it reaches the upper span. Or vice versa, short when the price moves into the cloud and close the short once it reaches the lower span. Similar to the base and conversion line, the price is often attracted to a flat edge of the cloud.

The Kumo Twist

The Kumo twist is when the cloud changes colour, when the Senkou spans cross over each other. For example, a change in trend is suggested to be imminent once the colour changes from red to green, implying that the downtrend may be over and that a new uptrend may be starting.

An example is shown below, where the colour of the cloud changes from green to red, forecasting a downtrend. Remember, the cloud is projected 26 periods into the future, so we’ve highlighted the Kumo twist and at which price point the Kumo twist signal was given.

As you can see above, we want to see a confluence of different bearish signals to go short, which we have in the chart below at the highlighted candle (i.e., the price is below the cloud, a thick part of the cloud provides resistance, and the Kumo twist has just occurred). Following the Kumo twist, the price then entered a strong downward trend.

Combining the Ichimoku’s Components: A Full Trading System

Now we’ve covered the main things to look out for when using the Ichimoku cloud indicator, it’s important to emphasize that all the signals mentioned above must be taken into the proper context.

As a full trading system, any analysis of the Ichimoku cloud indicator must consider all components. This will help you take on trades with more conviction and assess the risk of different signals provided by the Ichimoku cloud indicator.

When the price is above the cloud, any bullish signals will be stronger and bearish signals will be weaker.
Conversely, when the price is trading below the cloud, bearish signals are stronger while bullish signals are weaker.
If the price is within the cloud, any signals given by the indicator should be considered neutral.

For example, we know from the previous sections when the conversion line crosses above the base line, then it tells us bullish momentum is in play. However, if this signal occurs when the price is below the cloud, then it’s a weak bullish signal and it’s more risky to go long than if it had occurred when the price was above the cloud.

To analyze the Ichimoku cloud in a complete way, it’s best to start with looking at the price and its relation to the cloud (is the current price above, below or within the cloud?)
Then we can look at the area the cloud is in for potential support or resistance zones and its colour/slope for the current trend/momentum.
After analyzing the cloud and its relation to price, we can examine the base and conversion lines to identify the short-term trend and find potential areas of support and resistance.
Finally, we should look at the lagging line to gauge momentum, confirm trends, and identify other areas of support and resistance. For example, the lagging line confirms a trend when it moves above or below the Ichimoku cloud.

Example Trade Idea: Bullish

The chart below shows 5 bullish signals to look out for. There’s greater risk going long on weak bullish signals highlighted below, but the potential payoff is also higher.

However, once the price enters the cloud, we can position for a Kumo breakout, with a close above the cloud providing the first sign of an upward trend. Once the price breaks out, the long position can be executed with a greater likelihood of success as compared to the weak bullish signals. The strong bullish signals are exactly the same, but they occur when the price is trading above the cloud.

Some strategies for exiting the long include:

Waiting for a Tenkan cross, where the price closes below the conversion line (as highlighted in the chart)
Taking profit at a resistance level highlighted by a peak in the lagging line,
Using the 2.5*ATR rule of thumb to lock-in profits when the uptrend has over-extended,
Waiting for the Kumo twist (cloud changes colour from green to red).

Example Trade Idea: Bearish

For the bearish example, the first thing we’re looking for is a Tenkan cross (when the price closes below the conversion line) during an uptrend. The next signal to look for is the Kijun cross (where the price closes below the base line). Both signals are weak bearish signals, since the price is still trading above the cloud. The chart below also shows other bearish signals (numbered 1 to 5).

As the price enters the cloud, you can position for a Kumo breakout in either direction. But once it breaks out to the downside, this is the first real sign of a change in the long-term trend. Once entering a short using the weak bearish signals or the Kumo breakout, price targets can be set based on the supports indicated by the lagging line.

Other exit strategies in this scenario include:

Waiting for the first weak bullish signal when there’s a Tenkan cross below the cloud (as shown above),
Waiting for a Kumo twist (where the cloud colour changes from red to green),
Using the 2.5*ATR rule to exit the short where the downtrend is suggested to be over-extended.

Summary

The Ichimoku cloud indicator may be daunting at first, but as a complete trend-following trading system, it can help you identify short-term/long-term trends, price momentum and dynamic areas of support and resistance. With practice, you should be able to gauge the state of the market quickly and identify potential trading opportunities with ease.

In summary, the important signals to know are:

Bullish signals (which are considered strong when the price is above the cloud, or weak when the price is below the cloud)

Tenkan-Kijun cross: when the conversion line crosses above the base line, momentum has shifted from bearish to bullish.
Tenkan cross: the price closes above the conversion line.
Kijun cross: the price closes above the base line.
The “rubber band effect”: the price often finds support at the conversion line or the base line.

Bearish signals (which are considered strong when the price is below the cloud, or weak when the price is above the cloud)

Tenkan-Kijun cross: when the base crosses above the conversion line, momentum has shifted from bullish to bearish.
Tenkan cross: the price closes below the conversion line.
Kijun cross: the price closes below the base line.
The “rubber band effect”: the price often encounters resistance at the conversion line or the base line.