In our price action studies we have focused on trend indicators with the EMA 20 being a key feature in majority of the discussions. This in combination with various price action signals has offered excellent trade entries with impressive risk: reward ratios.
In this article we will introduce yet another powerful trend indicator, the Ichimoku cloud. The Ichimoku Cloud, also known as Ichimoku Kinko Hyo, is a versatile indicator that defines support and resistance and identifies trend direction. However we will only use two out of the five elements of this indicator:
Senkou Span A (Leading Span A): (Conversion Line + Base Line)/2))
This is the midpoint between the Conversion Line and the Base Line. The Leading Span A forms one of the two Cloud boundaries. It is referred to as “Leading” because it is plotted 26 periods in the future and forms the faster Cloud boundary.
Senkou Span B (Leading Span B): (52-period high + 52-period low)/2))
On the daily chart, this line is the midpoint of the 52 day high-low range, which is a little less than 3 months. The default calculation setting is 52 periods, but can be adjusted. This value is plotted 26 periods in the future and forms the slower Cloud boundary.
Combining the EMA 20, a lagging indicator, and the Ichimoku cloud, a leading indicator, can augment trend trading.
Let us look at a couple of ways in which the two can be combined:
A: Filtering out low quality Price Action Signals
In this chart of the EURUSD daily time frame, we can see that a bearsh price action signal occurring below a bullish cloud only yield about 50% of the pips in comparison to a bearish signal that occurs under a bearish cloud. This means a prudent trader would want to decrease his profit target levels for similar setups and increase the targets where the bearish signals occur below a bearish cloud.
B. Trade Targets
In the past we have used Fib levels, pivots and previous S/R levels as trade targets. Notably the Ichimoku cloud can also act as a target. The Senkou Span A and Senkou Span B act as future dynamic support and resistance levels
In the above example, a bearish pinbar occurred on the EMA 20 just above a bullish cloud. A trade entry and impulsive break to the downside followed for the next 5days. Price is then supported off the Senkou Span B and a bullish run follows. Using this lower end of the cloud in this instance could have enabled a trader harvest the maximum number of pips from the move.
Furthermore it is evident that price action signal off the EMA 20 while price is above a bullish cloud is an even better way to filter out high quality price action signals. The same applies to bearish signals below a bullish cloud.
We can therefore conclude that combining the Ichimoku cloud with the EMA 20 makes it easier to; filter out the quality of trade setups as well as offer realistic profit targets for trades taken when then two indicators are involved.