Today will not be about weather or sky-watching, although the rainbow pattern in the article title might presage such a discussion. Instead, we will talk about the non-standard use of moving averages to get a clear picture of the market and obtain valuable trading signals.

What is a rainbow pattern?

This graphical pattern includes use of three exponential moving averages with different periods. First with the period of six of blue color, second with the period of 14 of yellow color and third with the period of 26 of red color. We propose to use the expotential average. It is also possible to use a simple moving average or any other you feel comfortable with. The basis of the rainbow pattern is not the type of average, but the use of several averages of different periods.

EMA's settings for rainbow pattern
EMA's settings for rainbow pattern

These 3 averages are enough for us. I think it's not hard to imagine that you can add more of them in different colours to make the image even more rainbow-like. Often in studies on the rainbow pattern, we can find a recommendation that the averages should be with periods from 6 to 26 in intervals of 2. This would mean drawing as many as ten averages on the chart. We like simple things, hence we have 3 averages, as they are the quintessence of this pattern.

Trading signals based on rainbow pattern

Chart with 3 moving averages
Chart with 3 moving averages

Many participants believe that there exist the following powerful signals of asset price decline. The blue line with the period of six is above all others. The yellow line with a period of 14 is under the blue line.

Red line with a period of 26 is below all others. The intersection of the blue line with the period of six and the yellow line with the period of 14 is for most traders the point of access to the market and purchasing the option.

Price movement after intersection (down)
Price movement after intersection (down)

The probability of price increase is higher, if the blue line with a period of six is below all others, and the yellow line with a period of 14 is above the blue line. Red line with the period of twenty-six is above all others.

The intersection of the blue line with a period of six and the yellow line with a period of 14 is for most traders. The point of access onto the market and of purchasing the option.

Price movement after intersection (up)
Price movement after intersection (up)

In addition to the signals we have listed, these several moving averages plotted on the chart have additional values. Take a close look at your charts and look at the relationship of the averages in different situations. Notice what happens to a bunch of averages when the market is in a strong trend. You can see that the averages are strongly diverging from each other. In a consolidation of the trend they move closer together or even cross each other.

Remember, moving averages are not perfect. Mainly because they belong to the group of so-called lagging indicators. This means that they are calculated directly from the historical prices of an asset and their reaction is delayed relative to the price. They cannot show the future in any way. However, this in itself does not exclude their use as a signal generator in the form we have proposed today. We also encourage you to check our article about SMA strategy.

Do you have any experience with rainbow patterns? Describe them in the comments below.

We wish you successful trading with IQ option.

General Risk Warning: The financial products offered by the company carry a high level of risk and can result in the loss of all your funds. You should never invest money that you cannot afford to lose

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Bart Bregman

Fulltime Day trading, and help Iq option wiki in my spare time to build an awesome platform to help beginners out there. #digital-nomad, traveling all over the world. https://www.instagram.com/bart_bregman/

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