Zig Zag Indicator explained: How to read it and how to use it
The Zig Zag Indicator is a pretty useful tool for examining trends. Here, we explain what it is and how to use it.
What is the Zig Zag indicator?
The renowned investor Sir John Templeton once said:
"The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell."
If we want to follow his advice, then the Zig Zag indicator helps us to do that. A Zig Zag indicator shows the overall price-change trend over a period of time. You can set a percentage of a swing, meaning the little variations that always take place during trading are smoothed out, so the graph looks more like a series of straight lines, or zig zags, hence the name.
The great news is you can set the details yourself, meaning you have a chart that works the way you want it to.
How to read a Zig Zag indicator
The Zig Zag indicator is a way of looking at the overall direction of movement on a chart. Since we're looking at share prices let's use an example. Suppose X Company's shares start the month at $5. After a week, there have been some ups, but mostly downs, and it drops by 5%. The price then rallies, and ends up 5% higher a week later. During the rally, there have been a few minor drops in price, but the overall direction has been upwards.
If we just have a chart with the regular data, it looks like this. As you can see, there are a lot of ups and downs.
But if we have a Zig Zag indicator, it looks like this.
Looking at the chart with the Zig Zag indicator, it's easier to see what's been happening. We can see the value of the shares went down in the first week, then had a very strong rally in the second week. This means we can understand what the overall trend is rather than having to worry about very short-term moves. Using the Zig Zag indicator means it's easier to understand what's happening overall.
How to use the Zig Zag indicator
You've seen what the indicator does, so let’s look at how to use it. There are three different settings on the indicator. The first one is depth – this sets how far back in time you want to go.
The second is deviation, which sets how much of a percentage change in value you want to hit before the indicator changes direction. In other words, this will let you set when a zig becomes a zag.
The third one is backstep. If you're using a bar chart, this will let you know the number of bars between when a zig can become a zag. Since the indicator is used to map trends over time, it makes sense not to have too short a number of bars in your backstep. You want to see the overall pattern, not fluctuations.
If we want to get mathematical with things, the Zig Zag indicator formula looks like this:
How to use the Zig Zag indicator
Probably the first and most important thing to remember when using a Zig Zag indicator is that it does not predict the future. Rather, it tells you what has happened in a simple and clear way.
You can use this information to predict for yourself what might happen in future. If you want to do that, then you'll need to know about the Elliott Wave theory. That might sound a bit technical, but it's actually pretty straightforward. In the 1930s, the economist Ralph Nelson Elliott noted that stock charts didn't move in straight lines. For instance, a stock might go up twice and then down once.
Elliott believed these changes were driven by people and their emotions, rather than anything else. People investing in stocks might go back and forth from feeling positively or feeling negatively, meaning the movement of the prices look like waves. Where the Zig Zag indicator comes in is that it allows us to see where the waves have peaked and troughed over time.
But how do you estimate where peaks and troughs zig zag? We are going to have to use another mathematical idea.
The Fibonacci sequence starts 1,2,3,5,8,13,21,34,55 and continues ad infinitum, with each number being the product of the two preceding numbers. If you want to find the next Fibonacci point of any number in the pattern, you multiply it by 1.61 if you want to go up, or by 0.61 if you want to go down.
What's significant about this is that markets have a tendency to reverse the direction they're going in at various points on the scale. In percentage terms, the magic number is 61.8%.
So, let's draw six lines on a chart. The first is the highest point a stock has reached over a given time period, representing 100%, the second at 61.8%, the third at 50%, the fourth at 38.2%, the fifth at 23.6% and the final one, 0%, at the lowest point of price movement. They are all Fibonacci numbers, barring 50%, and they have a tendency of being, roughly, where changes in direction tend to take place.
Anyway, if we add the Zig Zag indicator it shows where all the upswings and downswings have taken place, as well as where they begin and end. If we note the Elliott Wave theory and use the Fibonacci sequence and the 61.8% ratio, we can have our own Zig Zag indicator strategy and maybe have a better chance of predicting when price trends will change.
As we can see, the Zig Zag indicator is a useful tool, but it's worth pointing out that it has its limitations. As we've already said, it tells you about the past, rather than the future. The last part of the zig zag will always be changing, so it's better to use it as a way to scrutinise a trend or to monitor how it's going.
It's also not going to predict any unexpected, unusual, events that could disrupt the market. However, it’s a useful tool, and it can be combined with other tools to help analyse markets and highlight patterns in prices that might not be clear on a conventional chart.
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