Monday, June 28, 2010

Patel, Trading with Ichimoku Clouds

Ichimoku Kinko Hyo is billed as an extension, perhaps even an evolution, of candlestick charting. I personally have never used it, so I approached Manesh Patel’s Trading with Ichimoku Clouds (Wiley, 2010) as a humble yet always skeptical novice. Since Ichimoku clouds are a price overlay, they clutter charts. Is the clutter worth it?

To enlighten my fellow novices here’s Ichimoku in a nutshell, extracted from Patel’s book. The system is made up of five components: (1) the 9-period average of (highest high + lowest low)/2; (2) the 26-period average of the same formula; (3) the current price shifted back 26 periods; (4) (formula 1 + formula 2)/2 shifted forward in time 26 periods; and (5) the 52-period average of (highest high + highest low)/2 shifted forward by 26 periods. The fourth and fifth indicators combine to make up the Kumo cloud.

The clouds are indications of current and future sentiment and the strength of that sentiment. They also provide support and resistance levels.

In the longest chapter of the book, complete with 135 TradeStation charts, Patel takes the reader through a two-year backtest of trading the EUR/USD cross following a set of bullish and bearish entry and money management rules. There were a total of eight trades. Although the system was profitable, it had a poor risk to reward ratio: the entry risk was 2,249 and the profit was 1,507, not exactly ideal. So Patel shows how one could optimize the strategy.

Patel rounds out his discussion by looking at other Ichimoku strategies (mainly crossovers and breakouts) and time elements in Ichimoku. Patel admits that he uses Gann’s time elements instead of Ichimoku’s.

For anyone interested in Ichimoku trading, this book sets out guiding principles that the systems trader could test, modify, meld into another system—the opportunities are, as always, seemingly infinite. With practice the Kumo clouds might offer up some insights to the discretionary trader as well. I admit I remained unconvinced, but for me this is primarily a question of style.

Perhaps I’m unconvinced in part because Patel has written such a refreshingly honest book. He could easily have cherrypicked his trade to make the strategy look like the holy grail. Instead, he offered up a profitable yet possibly flawed strategy (the sample size was too small to determine whether it was in fact flawed). He’s clearly not trying to sell snake oil.

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