Rainbow Moving Average – Rules, Strategy, Settings
Traders are always seeking new indicators to gain more insight into market trends and price movements, and this has led to the creation of the rainbow moving average. What do you know about the indicator?
The rainbow moving average is a unique technical indicator that displays multiple moving averages of different periods on the price chart at once. The second and subsequent constituent moving averages are calculated based on the preceding moving average. Each of the constituent moving averages is given a different color — with the multiple colors giving the indicator the unique appearance of a rainbow on the chart.
In this post, we will take a look at some of the questions you may have about the rainbow moving average: what it is, how it works, and how you can improve your trading strategies with it. Let’s dive in!
Key takeaways
- The rainbow moving average is a technical indicator that displays multiple moving averages of different periods on a price chart.
- The moving averages are usually simple (SMAs), but can also be exponential (EMAs), linear-weighted (LWMAs), or other types.
- The key feature is that it consists of multiple moving averages in one indicator, with each subsequent moving average calculated based on the preceding one.
- Each moving average is displayed in a different color, creating a rainbow-like visual effect on the chart.
- Typically, it includes around 10 moving averages but can have up to 22.
- The first moving average is calculated directly from price data, while the rest are derived from preceding moving averages.
- More indicators if you click here: top trading indicators
What is a Rainbow Moving Average?
The rainbow moving average is a unique technical indicator that displays multiple moving averages of different periods on the price chart at once. The constituent moving averages are usually of the simple moving average (SMA) type but can also be created with the exponential (EMAs) or linear-weighted (LWMAs) or any other moving averages.
The unique thing about the rainbow moving average is that it consists of multiple moving averages in one indicator. The second and subsequent constituent moving averages are calculated based on the preceding moving average. Each of the constituent moving averages is given a different color — with the multiple colors giving the indicator the unique appearance of a rainbow on the chart. The number of constituent indicators is usually about 10 but can be as many as 22, and each is of an MA of the preceding MA, apart from the very first one, which is calculated from the price data.
Rainbow Moving Average trading strategy – rules, settings, and returns
A backtested strategy is coming shortly.
How does the Rainbow Moving Average work?
The rainbow moving average works by combining multiple SMAs or EMAs, each representing a moving average of the preceding moving average to offer progressive smoothening. The uniqueness of the indicator lies in the different colors of each moving, giving it a rainbow appearance on charts.
Usually, the warmer colors are used for earlier MAs, while the cooler hues are used for longer-period SMAs with more smoothening. When the early layer (shorter-period) MAs stay above the subsequent layer (longer-period) MAs and keep rising further away from the latter, the market is in an uptrend. The same is true when it happens on the downside, where it indicates a downtrend. The farther away the primary SMA is from the last ones, the stronger the trend, while the closer they are together, the weaker the trend.
Why is it called a Rainbow Moving Average?
It is called a rainbow moving average because it consists of multiple moving averages of different smoothening, and each of them is assigned a specific color, thereby giving the appearance of a rainbow on the chart.
There are usually about 10 moving averages in one rainbow moving average indicator. The primary moving average is an n-period SMA of the price data (usually the close price). The subsequent MAs are each an MA of the preceding MA. With the multiple moving average lines with different colors displayed on the chart, the indicator gives the visual appearance of a rainbow. The bright colors may be catchy to some traders, enabling them to assess the trend better.
What are the different layers in a Rainbow Moving Average?
The different layers in a rainbow moving average are made of SMAs of the moving average preceding them. Interestingly, each of these SMAs is assigned a certain color. For example, if a 9-period SMA is the primary SMA calculated from the price data, the second layer would be a 9-period SMA of this primary SMA. The third layer would be a 9-period SMA of the second layer SMA. It continues like that to the 10th layer.
Each of the layers is given a specific color in the rainbow spectrum. So, the first layer MA (the primary MA) is assigned a red color, and the second layer is assigned an orange color. The third layer is given a yellow color, and it continues like that for the rest of the SMAs that make up the Rainbow indicator.
How does a Rainbow Moving Average differ from other moving averages?
A rainbow moving average differs from other moving averages in that it is one indicator that plots multiple moving average indicator lines on the chart. The constituent moving averages are of different colors, representing their different lookback periods. This is unlike other moving averages that plot a single line with its given color on the chart. Due to its multiple constituent moving averages with their different colors, the rainbow indicator gives the appearance of a rainbow on the chart, while the other types of moving averages just plot a line of one color on the chart.
What timeframes can you use with the Rainbow Moving Average?
You can use the rainbow moving average on any timeframe of choice. The timeframes you choose to use with the indicator will depend on your trading style and strategy. If you are a scalper, you will obviously trade on the lowest timeframes, such as the 1-minute and 5-minute charts or even the seconds chart or the tick chart. You can use the indicator on those timeframes provided it gives you an edge based on your strategy.
Likewise, if you are a swing trader, you may be looking for your setups on the 4-hourly and daily timeframes, and you can use the indicator there too. What matters is that you have a backtest strategy that has an edge in the market.
How can you set up a Rainbow Moving Average on your trading platform?
You can set up a Rainbow Moving Average on your trading platform by following these steps:
- Check if the indicator is among the built-in indicators on the trading platform you are using — While most trading platforms come with pre-installed indicators, the rainbow moving average may not be one of them.
- If the indicator is not already pre-installed in your trading platform, you will have to get a custom-made rainbow moving average for the trading platform and install it yourself.
- Now, go to the indicator section of the platform, double-click on the indicator, and drag it to your chart.
- Input your preferred settings on the indicator box that appears and click OK.
What is the best period setting for a Rainbow Moving Average?
The best period setting for a rainbow moving average indicator will depend on the market you are trading and the strategy you are trading. You may have to experiment with different periods for the different constituent SMAs to know what works best for your strategy and the market you are trading. It is important to use the settings that provide your strategy with an edge in the market. The only way to know the best period settings is by backtesting your strategy using different periods and periodically evaluating the performances to find the settings that work best.
How do you interpret signals from the Rainbow Moving Average?
How you interpret the signals from the rainbow moving average depends on your trading approach. You may look at the last-layer SMAs for trend direction and the first-layer SMAs for price swings to determine your entry and exit.
However, the general interpretation is that when the early-layer SMAs stay above the last-layer SMAs and keep rising further away from the latter, the market is in an uptrend. Likewise, when the early-layer SMAs stay below the last-layer SMAs and keep falling further away from the latter, the market is in a downtrend. The faster the SMAs are rising or falling — as the case may be — the stronger the trend, while the closer they are together, the weaker the trend.
Can the Rainbow Moving Average predict market trends?
No, the rainbow moving average cannot predict market trends, but it can be used to ascertain the direction of an ongoing trend. Basically, the direction of the slopes of the constituent moving averages indicates the direction of the trend.
So, in an uptrend, the moving averages would be sloping upward, while in a downtrend, they would be sloping downwards. To know the strength of the trend, check how fast the MAs are rising or falling.
How do you identify entry points using the Rainbow Moving Average?
How you identify entry points using the rainbow moving average would depend on your trading strategy. However, the usual thing is to use the faster-moving averages, which track the short-term price swings, to trade in the direction of the main trend. In an uptrend, an entry point could be when the fastest SMA moves back above the slower, last-layer SMAs after falling below them during a pullback.
The opposite can be used in a downtrend — when the fastest SMA moves back below the slower SMAs after rising above them during a pullback, it could be a time to short.
How can you use the Rainbow Moving Average to identify exit points?
How you use the rainbow moving average to identify exit points would depend on your trading strategy. But the usual thing is to use the faster-moving averages, which track the short-term price swings, to identify a countertrend movement. For example, if you have a position in the direction of the trend, say an uptrend, you monitor the fastest SMA to know when it turns downwards and then exit your position. Similarly, if you are in a short position in a downtrend, you monitor the fastest SMA to know when it turns upwards, indicating an emerging up move. At that point, you exit your short position.
What are the advantages of using a Rainbow Moving Average?
The advantages of using a rainbow moving average include the following:
- The indicator can be used to spot the different trends in the market, both the long-term and short-term trends.
- It can give an idea of the support and resistance levels — the last-layer SMAs can serve as dynamic support and resistance levels
- It can give trading signals, as the fast, first-layer SMA can be used to spot potential entry and exit points.
- The gap between the first-layer SMAs and the last-layer SMAs can be used to assess the level of volatility in the market.
Are there any drawbacks to using the Rainbow Moving Average?
Yes, there are some drawbacks to using the rainbow moving average. Here are some of them:
- The rainbow indicator is based on moving averages, which lag the price because they are calculated past price data and smoothened several times.
- The indicator cannot tell you what will happen next in the market, as it only tells you how the price has moved in the past.
- It is prone to many false signals, especially in a ranging market or during a rapidly changing market condition.
How does the Rainbow Moving Average perform in trending markets?
The rainbow moving average performs best in trending markets. This is because it is based on moving averages, which are known to perform well in trending markets. When the market is in an uptrend, the indicator’s moving averages will normally align and slope upward, trailing below the price.
In a down-trending market, the moving averages will align and slope downward, trailing above the price. When trading in such conditions, the indicator’s last layer can be used to guide a trailing stop to ride up or ride down (as the case may be) the trend.
How effective is the Rainbow Moving Average in ranging markets?
The rainbow moving average is not effective in ranging markets, as it is prone to many false signals in such markets. Being a trend-following indicator, the rainbow moving average gives late signals in ranging markets, and by the time you enter a trade, the price has already reached the end of the range and reversing to the other direction.
So, you will get stopped out a lot of the time trying to trade with the indicator in this type of market condition.
What other indicators work well with the Rainbow Moving Average?
Other indicators that may work well with the rainbow moving average are the average directional index (ADX) and the oscillators. The ADX may help to identify an emerging trend and gauge the strength of a trend so the trader can use the rainbow moving average to trade and trail profits.
For swing traders, oscillators can help to confirm tradable price swings in the direction of the trend identified with the rainbow moving average.
How does the Rainbow Moving Average help in risk management?
The rainbow moving average does not directly help in risk management, as it does not show you the position size to use and where to key keep your initial stop-loss order. However, you can use it to create a trend-following trading strategy with specific risk management parameters.
In addition, if you are in a profitable trade, the last layer of the rainbow moving average may be used as a guide for your trailing stop loss if you intend to ride the trend to its end.
Can you combine the Rainbow Moving Average with candlestick patterns?
Yes, you can combine the rainbow moving average with candlestick patterns if you have a strategy that works with both to give you an edge in the market — the most important thing is to have a strategy with an edge. Your strategy could be to go long in an uptrend when the market pulls back to the last layer of the rainbow indicator and forms a reversal candlestick, such as the hammer or bullish engulfing pattern.
Make sure you backtest any strategy before putting your money on the line.
How do professional traders use the Rainbow Moving Average?
Professional traders use the rainbow moving average to identify strongly trending markets and trade in that direction. The indicator is mostly suited for trend-following traders. Such traders can enter a trade and choose to ride their profits till the trend ends.
They use the rainbow moving average to guide their trailing stop when riding a trend. Some other professional traders may combine the rainbow moving average with other indicators and tools to create swing trading strategies.
Is the Rainbow Moving Average suitable for day trading?
The rainbow moving average may be suitable for day trading if it is used to create a day trading strategy with a proven edge. Although it is a trend-following indicator, trends can be seen in any timeframe, including the intraday timeframes used in day trading.
So, day traders can create profitable trend-following strategies with the rainbow moving average, provided the strategies are used in trending markets.
Can the Rainbow Moving Average be used in long-term investing?
Yes, the rainbow moving average can be used in long-term investing if it is used to create a profitable trend-following strategy that works in markets with long-term trends.
In markets with long-term trends, such as the Dow 30 and S&P 500 indexes, the indicator can be used to create a trend-following strategy on a higher timeframe, such as the monthly or weekly timeframe, where it can track a multi-year trend.
How do you backtest a Rainbow Moving Average strategy?
To backtest a rainbow moving average strategy, you can follow these steps:
- Choose the markets you want to backtest the strategy
- Gather the data you need for the backtesting and divide them into in-sample and out-of-sample data.
- Formulate the rules of the rainbow moving average strategy you want to backtest.
- Code the strategy into trading algorithms.
- Run your backtesting on the in-sample data and optimize with the out-of-sample data, adjusting your parameters as needed.
- Evaluate the results of your backtesting.
What are common mistakes traders make with the Rainbow Moving Average?
The common mistakes traders make with the rainbow moving average include:
- Using it to trade in a range-bound market
- Not defining and managing their risks properly
- Using the indicator as a standalone strategy
- Thinking that the market trends all the time or that a trend has no end.
How can you optimize the Rainbow Moving Average for your trading strategy?
To optimize the rainbow moving average for your trading strategy, you have to regularly evaluate the strategy to see how well it is performing. When it is not performing as expected, you can tweak the parameters and backtest it again with the new parameters.
You keep running the testing until you get the parameters with the best performance. Then you forward-test and repeat the evaluation-tweaking-and-testing cycle when needed.