Being able to pinpoint the location of opportunities within a chart is the utmost desire of every trader. While indeed this is no easy feat, there are a few ways on how to plot and draw lines that can help a trader take advantage of the opportunities within a chart. Among the most effective way to identify lines, curves, patterns, and trends within a chart is through the use of indicators. Indicators enable a trader to see the unseen within a chart. Through indicators, entry, as well as exit points, can be easily identified, and a trader can even use it to measure price increase or decrease within a given range. For this particular write-up, we’ll be talking about the Moving Average indicator and how we can make the most out of it through the Rainbow Pattern.
What is a Moving Average?
Before we proceed further with the Rainbow Pattern, it is important to understand its basic component which is the Moving Average.
The Moving Average is just one among the dozens of technical indicators used in trading today. Furthermore, it is the most used indicator because of its increased level of accuracy that makes use of actual price history. One of the main reasons why traders use the MA or Moving Average indicator is to smooth out the price movement in the chart. As the curve from the MA indicator is drawn, the trend becomes more visible, and significant price points or levels become more obvious. By being able to see these price points, a trader can make better assumptions regarding ideal entry and exit points within a chart.
there are two kinds of Moving Averages used by traders depending on their preference and objective. These kinds of MA include the Exponential Moving Average and the Simple Moving Average. The SMA (Simple Moving Average) and the EMA (Exponential Moving Average) are computed using different formulas. In addition, EMA adapts more quickly to price change compared with SMA.
What is a Rainbow Pattern?
A Rainbow Pattern is a collection of Moving Average indicators on a chart. The Rainbow is characterized by three distinct MA colors which can be varied or changed depending on the trader’s preference. The first color is color blue which makes use of a 6-day period moving average, followed by a color yellow that represents a 14-day period MA, and red color for the 26-day moving average indicator. The periods of 6, 14, and 26 days can be changed depending on the traders’ preference however these numbers are usually what’s commonly used by most traders today to represent the Rainbow pattern.
For the particular moving average used for the Rainbow pattern, it is ideal to use the EMA (Exponential Moving Average) because of its quick adaptability to price change. This characteristic of the EMA is beneficial for day traders as well as swing traders who want quick data out of quick price movements.
On the image above, the blue arrow and line represent the 6-day period, the yellow arrow and line for the 14-day period, and the red arrow and line for the 26-day period. Notice the way the blue line stays on top while it is on an uptrend, and when it stays below the other EMAs during a downtrend. The same goes with the other EMA colors.
The Rainbow Pattern helps identify the ideal entry and exit points in a chart through the intersection of the three EMAs. One basic rule of the Rainbow Pattern is that whenever these three EMA lines intersect, you should either buy or sell – not following this rule can incur huge losses.
The pattern gives a ‘buy’ or ’long trade’ signal whenever the lower range EMA (which in this case is the 6-day EMA) intersects the other EMAs and moves upward. On the other hand, it’s a ‘sell’ or ‘short trade’ signal whenever the higher range EMA (in this case is the 26-day EMA) intersects the other EMAs and move downwards.
As an illustration, let us check out this chart from ETH (Ethereum) from eToro.
Notice the red and green arrows on this illustration. These arrows show the instances where the EMAs cross or intersect each other.
The red arrows on this image show how the red EMA (26-day period) intersects both the other EMAs (yellow and blue EMAs) and moves on top of them. As discussed earlier, whenever EMAs cross or intersect each other, the point of intersection becomes an entry or exit point. Without indicators, and with just looking at the candles alone, one may not be able to identify these exit or entry points. For this case, whenever the red EMA is on top of the other EMAs, it shows a good opportunity to short or sell positions since the trend is about to go downward.
On the other hand, the green arrows show how the blue EMA (6-day period) dominates the other EMAs. The green arrow displays where the ideal entry point or point where to go ‘long’ is located within the chart.
One thing to note in this example is that the significant EMAs (blue and red) should cross the other EMAs for the trade to become successful. On the second green arrow, notice how blue EMA crossed the yellow EMA first before crossing the red EMA. There will be some instances where an EMA crosses one EMA but not the other. For such cases, it would be ideal to wait and hold until both EMAs are crossed since this event could lead to a consolidation or trend reversal.
Moving averages are just normal lines in a chart that follows price action – it really can’t do much on its own. However, if interpreted and used strategically, it becomes a lethal weapon in trading. The Rainbow Pattern is one effective and sound strategy that takes the capabilities of the Moving Average indicator into a full advantage. It gives a clear view of the ideal entry and exit points within a chart using any range – whether it is a daily, hourly, or per minute range. With this, it becomes an ideal tool and strategy for any trader regardless of their styles – such as day trading, swing trading, momentum, or position trading.
Of course, the Rainbow Pattern is not an all-in-one indicator that can tell a trader everything about a chart. It should be used accordingly depending on the trend and case of the market. Markets in consolidation would not be an ideal place to implement the Rainbow Pattern due to the low volatility or slow price change. Lastly, a trader would also be able to improve the efficiency of the Rainbow Pattern by combining it with other indicators such as RSI, MACD, Parabolic SAR, and others.
Of course, to effectively use this pattern, one should gain experience using it. The best way to exercise this pattern on a real-time trade is through an eToro virtual account. This account lets you trade with a real-time market on eToro while using virtual funds.
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