Zig Zag

Definition

The Zig Zag indicator is used to identify price trends, and in doing so plots points on the chart to mark whenever prices reverse by a larger percentage point than a predetermined variable or marker. The points are connected by straight lines that help the trader visual the price action. This indicator works to eliminate confusion over small price changes or fluctuations and aims to project trend changes overtime. 

Calculations

The Zig Zag indicator can be calculated with the following formula:

ZigZag (HL, % change = X , retrace = FALSE, LastExtreme = TRUE)
If  % change > = X, plot ZigZag  

Definitions

HL = High-Low price series or Closing price series

% change = Minimum price movement (as a percentage).

Retrace = This can be the change in the retracement of a previous move, change a retracement of the previous move, or it can also be an absolute change from peak to trough.

LastExtreme = This references extreme price, if it is the same over multiple periods (usually the first or last price observation).

Take the following steps to calculate the Zig Zag indicator:

  1. Begin by picking your starting point (swing high or swing low).
  2. Next, choose your % price movement.
  3. You’ll then need to identify your next swing (swing high or swing low), making sure that it is different from your starting point.
  4. Then draw a trendline from the starting point to the new point.
  5. Again, identify your next swing high or swing long, making sure that it is different from the point you created in Step 3.
  6. Draw a new trendline connecting these points.
  7. Repeat these steps for the next swing high or swing low.

Takeaways

By filtering out small price movements, the Zig Zag indicator is able to keep the trader’s focus on trends and their direction. The Zig Zag indicator is great for highlighting trend direction and lowering noise levels. It works best with strong, trending markets. The Zig Zag indicator doesn’t assess or predict future trends, however, it does help identify and plot swing highs and swing lows. 

Limitations

Similar to many other trend-following indicators, the Zig Zag indicator projects buy and sell signals that are based on historic and past prices that do not always predict the future direction of price trend. That being said, it is not unheard of for a Zig Zag line to appear after the majority of a trend has already come and gone.

Traders should take note of this and should also be aware of the fact that Zig Zag lines are not always permanent. If there is a price reversal, the indicator will start drawing a new line. If this new line doesn’t reach the percentage setting defined by the indicator, and in addition, the security’s price reverses direction, then the line is removed from the chart and replaced with an extended version of the Zig Zag line that then matches the original direction of the trend.

Due to lag, some traders will use the indicator in order to confirm trend direction and therefore strength or weakness, instead of trying to make a perfect entry or exit. This can be a limitation because the readings are never 100% accurate. Lag can also affect the reading of the indicator. Traders should be aware of this when using the Zig Zag indicator and should also consider using it in addition to other trend-following indicators in order to get more accurate and profitable trade results.

Summary

The Zig Zag indicator identifies price trends and plots points on the chart to mark price reversals when they differ by a larger percentage point than a predetermined variable. The points are connected by straight lines that help the trader determine overall price trends. Zig Zag indicator lines appear when there is significant movement between swing highs and swing lows. The indicator also helps filter out any small price movements, making it easier for the trader to focus solely on the trend, its direction, and its strength levels.

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