Ichimoku Trend Following Strategy

Mar 11, 2021

Like candlesticks, the Ichimoku indicator is a fine Japanese creation.
Here I’ll explain how the Ichimoku is plotted, and use it to build a trend following strategy for the USDJPY.
The complete strategy can be downloaded in the Free Strategies section.

Candlesticks have revolutionized the world of technical trading – encyclopedias of candlestick patterns have been written.

When I first heard of the Ichimoku and its Japanese origins, I knew I had to check it out.

Ichimoku in a Nutshell

The Ichimoku Kinko Hyo, translated to one glance equilibrium chart, is a popular trend following indicator. It helps traders quickly discern market direction and support/resistance levels.

The Ichimoku is included in MT4 and is plotted below for the 4-hour USDJPY.

It consists of 5 lines:

1. Tenkan-sen

Also called the conversion line, the Tenkan-sen is the average of the highest high and lowest low over the past 9 periods.

It is akin to a fast moving average, and is commonly used to generate entry signals (we’ll get to that later).

2. Kijun-sen

Also called the base line, the Kijun-sen is the average of the highest high and lowest low over the past 26 periods.

It reacts more slowly than the Tenkan-sen, and is often used as a key support/resistance level.

3. Chikou Span

Also called the lagging span, the Chikou is the current close plotted 26 periods back.

It helps detect breaks of support and resistance levels.

If the Chikou crosses above the price, it implies a break of resistance, and the market is bullish.

Conversely, if the Chikou crosses below the price, it implies a break of support, and the market is bearish.

Ideally, you should only jump onboard a trend when the Chikou is clear of prices.

4. Senkou Span A

The Senkou Span A & B each form one edge of the cloud, or Kumo.

The Span A is calculated as the average of the Tenkan-sen and Kijun-sen, plotted 26 periods ahead.

5. Senkou Span B

The Span B is the average of the highest high and lowest low over the past 52 periods, also plotted 26 periods ahead.

The Kumo represents a support/resistance zone for the market. In general,

  • The market is bullish when prices are above the Kumo, and bearish when prices are below the cloud.
  • A thick Kumo is a result of a volatile market, and provides stronger support/resistance.
  • An upward sloping Kumo indicates a bullish market, while a downward sloping Kumo indicates a bearish market.

Later on in the post, I will use the Kumo as an entry filter when building the trend strategy.

I do not recommend tweaking the default lookback periods of 9, 26 and 52.

Legend has it that the Ichimoku’s creator spent 30 years perfecting it; the values provide a good short and mid-term outlook for the market.

Ichimoku Trend Following Entries

I will illustrate three common trend following entries with the Ichimoku.

1. Tenkan-sen & Kijun-sen Crossover

When the Tenkan-sen crosses above the Kijun-sen, the market exhibits bullish momentum, and a buy signal is produced.

Conversely, when the Tenkan-sen crosses below the Kijun-sen, the market exhibits bearish momentum, and a sell signal is produced.

There are three signal strengths, depending on where the Tenkan-Kijun crossover occurs relative to the Kumo.

  • If a bullish crossover occurs above the Kumo, the signal is strong.
  • If a bullish crossover occurs inside the Kumo, the signal is neutral.
  • If a bullish crossover occurs below the Kumo, the signal is weak.

The converse applies for bearish crossovers. If a bearish crossover occurs below the Kumo, the signal is strong, and so on.

The chart below shows a strong bullish Tenkan-Kijun crossover.

2. Price & Kijun-sen Crossover

When price closes above the Kijun-sen, the market exhibits bullish momentum, and a buy signal is produced.

Conversely, when price closes below the Kijun-sen, the market exhibits bearish momentum, and a sell signal is produced.

Like the Tenkan-Kijun crossover above, signal strength depends on the Kumo location.

The chart below shows a strong bullish Kijun crossover.

3. Kumo Breakout

A buy signal occurs when price breaks and closes above the Kumo.

A sell signal occurs when price breaks and closes below the Kumo.

These signals occur frequently. To improve your win rate, I recommend only taking trades when the Kumo is sloping considerably.

Flat Kumos are usually the result of an unchanged Senkou B (average of the highest high and lowest low over 52 periods) and indicate a strong support/resistance zone. Prices tend to retreat back towards the Kumo in such cases.

If the breakout occurs during a flat Kumo, have a look at the ‘future’ Kumo (remember that both Senkou A & B are plotted 26 periods ahead).

If the future Kumo starts sloping, as shown in the chart below, the probability of trend continuation is higher.

I have backtested all three Ichimoku strategies, and I find that the Tenkan-Kijun crossover usually produces the best results.

This may be because the Tenkan and Kijun average price action over the past 9 and 26 periods, respectively. This helps eliminate false entries.

The price-Kijun crossover and Kumo breakout strategies, in contrast, directly use the current close to generate signals.

From here on out, I’ll build a USDJPY trend following strategy using the Tenkan-Kijun crossover.

Tenkan-Kijun Crossover Ichimoku Strategy

Entry Conditions

To get a higher win rate, I’ll only focus on strong Tenkan-Kijun crossovers. To recap, this means the crossover has to occur above the Kumo for longs, and below the Kumo for shorts.

In addition, I want price to close above the Tenkan for longs, and below the Tenkan for shorts. This ensures short-term momentum is in my favour.

When the above entry conditions are met, I’ll place a buy stop at the previous high, or a sell stop at the previous low.

Trade Management

Ichimoku traders often use the Kijun as a stop loss and trailing stop. This is a sensible option, and is similar to using a medium-speed moving average.

Unfortunately, with the entry conditions above, there will often be insufficient breathing space between the entry price and the Kijun. The chart below shows an entry with a 30-pip stop loss distance, which is too small for the 4-hour USDJPY. Stops that are too tight are usually a recipe for disaster.

One way to alleviate this is to place a buffer between the Kijun and stop loss. For example, for long trades, you can place the stop at one ATR below the Kijun.

For this case, instead of using the Kijun, I will simply implement an 80-pip stop loss and trailing stop.

Finally, to avoid weekend gaps, I will exit the trade on Friday, at 4pm New York time.

Programming the Ichimoku Trend Following Strategy

The above entry conditions were visually programmed as shown.

AlgoWizard contains a pre-programmed Tenkan-Kijun crossover condition, so you just need to select the signal strength.

For the price > Tenkan condition, select the Tenkan line under the Ichimoku indicator.

The trade management conditions were then added:

Backtesting the Ichimoku Trend Following Strategy

The strategy will be tested on the 4-hour USDJPY from May 2003 to March 2021.

As mentioned above, trades will be closed on Friday at 4pm New York, which occurs while a bar is still in progress.

To improve precision, I will use the ‘1-minute data tick simulation’ backtest model. With this model, OHLC prices on the 1-minute timeframe are used to simulate tick movement.

The equity curve is consistent, and the 1.74 profit factor is pleasing.

There are only 165 trades in the backtest though, which translates to about 9 trades per year. This is one reason I prefer not to trade anything above the 1-hour timeframe.

On the bright side, part-time retail traders can easily trade this for side income. All you have to do is plan your toilet breaks in advance. tongue-out

Wrapping Up

The Ichimoku is a nifty indicator that conveniently conveys the market’s sentiment.

Its five lines may initially seem daunting, but they are certainly capable of generating reliable trend following entries.

The strategy presented above, while pretty decent, is only an ‘entry level’ Ichimoku strategy.

You can improve the strategy by adding more entry filters.

For example, you can evaluate the Kumo’s slope and thickness. A thick, upward sloping Kumo bodes well for long trades.

Or you can check the Chikou’s location relative to prices. You want the Chikou to be clear of prices, which indicates that support/resistance has been broken.

Such refinements will likely be necessary if you intend to use the Ichimoku for trend following on the lower timeframes.

As usual, the completely strategy can be downloaded in the Free Strategies section.

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