Equities Trading Strategy - The Ichimoku Kinko Hyo

Equities Trading Strategy

Introduction

The Ichimoku Kinko Hyo is a highly versatile trading indicator. In fact it is a set of indicators that gives traders a complete overview of the market. It was developed in the previous century by a Japanese journalist by the name of Goichi Hosada. He worked on it for more than two decades to further refine it and later published his findings in a 1959 book.

It is still not widely known in the West, although its popularity is on the rise. In Japan it’s hard to find a trading room without an Ichimoku Kinko Hyo chart somewhere on a screen or against a wall.

The trading strategy for equities we set out below uses the Ichimoku chart in Fig. 5.17. The reason for this is that the strategy is very much based on trend following, which is what the Ichimoku was developed for in the first place.

Strategy

In Fig. 5.17 you will see a graph depicting the daily price of the DAX from April 2010 until May 2011. During this period the price moved gradually upwards, then went through a major correction but still closed more than 1 000 points above its closing price on the 19^th of April last year.

If we followed the simple trading strategy below, we would have captured most of the upswing and made a very nice profit.

First requirement – The price must be above the Ichimoku Kinko Hyo cloud before a bull market is indicated.

Requirement B – The green Chinkou Span line must be above the price 26 periods ago. The Chinkou Span is the current price plotted 26 days in the past. Since the Ichimoku is in the first instance a trend indicator, this is simply a visual way of immediately showing us that the current price is higher than the price 26 days ago, indicating a bull market.

Requirement C – The price must be above the red Tenkan-Sen line. The Tenkan-Sen depicts the average of the high and low prices for the past 9 periods and, as such, is similar to a short-term average. If the price moves above this line, it simply indicates that the longer term bull run is confirmed by a short-term upturn in the price.

Requirement D – The red Tenkan-Sen line must be above the blue Kijun-Sen line. The Kijun-Sen is the average of the highest high and the lowest low for the past 26 periods. It is therefore a longer term average. When the shorter term Tenkan-Sen moves above the longer-term Kijun-Sen it therefore acts as short-term confirmation of the longer term bull market.

For a short position, the requirements should of course be reversed: the price has to be below the cloud, the Chinkou Span must be below the price 26 periods ago, the price must be below the red Tenkan-Sen, and the Tenkan-Sen must be below the Kijun-Sen.

Practical Application

Returning to Fig. 5.17 we see that at point A1 the first three requirements are met. The price has just moved out of the cloud, the green Chinkou Span line is above the price 26 periods ago and the price is also above the red Tenkan-Sen short-term average.

The last requirement, that the red Tenkan-Sen line must be above the blue Kijun-Sen, has not been met yet. In this particular case it would have been worked out well if you did not wait for this to happen, but it might also have been otherwise.

When the red Tenkan-Sen lines moves above the blue Kijun-Sen at point A2 in Fig. 5.17, we have received another short-term confirmation of the longer term bull market. Going long at this point would have given us a nice profit of several hundred points, depending on what we used as a stop loss point.

Stop Loss

Using the red Tenkan-Sen Line as a stop loss is very conservative and would have kicked you out of an otherwise profitable trade several times. The blue Kijun-Sen would have been a better option. It would have kicked you out of the trade on the 30^th of November and again on the 10^th of January, only to enter again when the price returned above the level of the Tenkan-Sen. Eventually this strategy would have become erratic towards the end of February/beginning of March, with several false exits and entries before the price finally dropped back into the cloud.

The best option would have been to use the cloud itself as an exit strategy – in other words exit the trade the moment the price drops back into the cloud. This would have given us the biggest profit and the lowest number of false entries/exits.

Conclusion

At Point B all four requirements above were again met – this time for a short trade, but there wasn’t much profit in that particular trade. An early exit, e.g. the red Tenkan-Sen, would have worked best in this instance.

At point C all four requirements for a bull market were once again met. The price subsequently moved up just over 200 points, but has now retracted to a level below both the Kijun-Sen and the Tenkan-Sen.

A cautious trader will wait for a continuation signal, such as the price moving above the red Tenkan-Sen again, before entering a long position. If the price moves down further and enters the cloud, wait for the requirements for a short position set out above to be met.

Fig 5.17