The Zig-Zag indicators uses both swing highs and swing lows in its calculation:
- Swing Highs: When a price (usually close) is both higher than the price previous to it and after it.
- Swing Lows: When a price is both lower than the price prior to it and lower than the price following it.
The Zig-Zag indicator can use both percentages or points in its construction. To construct the Zig-Zag indicator, there must be a certain percentage or number of points between a swing high and a swing low before a line will be drawn.
The chart below of the E-mini Nasdaq 100 Futures contract visually illustrates the difference between a price retracement Zig-Zag of 3% and a price retracement Zig-Zag of 5%:
Notice how in the chart above that a Zig-Zag with a retracement percentage of 3% makes more distinct lines than the Zig-Zag with a retracement percentage of 5%. The purpose of using a Zig-Zag with a larger retracement percentage is to help eliminate price noise that is not significant for the trader's analysis.
As will be shown on the next page, the Zig-Zag can be helpful in uncovering stock cycles while screening out short-term price noise.
Zig Zag Interpretations
The Zig-Zag indicator can be effective in filtering short-term noise and identifying significant trends and significant changes in market prices.
Below is a chart of the E-mini S&P 500 Futures contract that illustrates how effective the Zig-Zag indicator was in visually finding areas of support and resistance and price breakouts:
The chart above of the e-mini uses a 5% Zig-Zag retracement value; therefore, only price changes of 5% or greater are shown, helping a long-term trader or investor identify important areas of support, resistance, and areas of price breakouts.
On the left of the chart, the S&P 500 was forming a triangle consolidation pattern. When prices broke resistance, a potential long-term buy was generated. During the middle of the chart, the Zig-Zag indicator was effective in illustrating that the S&P 500 was in an upward price channel. Typically traders might wish to buy in areas where price touched the lower support trendline and sell when prices touched the upper resistance line.
The chart below of Intel (INTC) shows a classic chart head and shoulder pattern easily seen by the Zig-Zag indicator ($1 retracement):
The easily identified head and shoulders pattern gave a potential sell signal when price on the right shoulder broke the upward slanting trendline.
The Zig-Zag indicator is a technical analysis tool that might be used to identify classic charting patterns. The Zig-Zag indicator is also effective in visually reducing noise and helping the technical trader see larger picture patterns and general market direction.
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