The Zig Zag indicator is what is known as a filtering or smoothing indicator. Its primary purpose is to filter out insignificant fluctuations in the price of a security and accurately track whatever the existing trend is. It can also be used to identify support and resistance price levels in a market.
It’s also sometimes used by technical analysts who use Elliott Wave Theory analysis to help identify the beginning and end of each wave in a cycle.
By filtering out “noise” – insignificant price movements that occur within a sustained, long-term trend – the Zig Zag indicator is designed to help traders maintain a profitable market position throughout a sustained trend.
The Zig Zag indicator draws its own trendlines that are created or adjusted only when there is a price movement greater than a designated percentage amount. The default value on most versions of the indicator is 5%, meaning that the Zig Zag indicator will not register any fluctuation in price that is less than 5%. Traders and market analysts can, of course, set their own minimum percentage values for the indicator. Values between 6% and 10% are commonly used variations from the default 5% value.
By not reacting to all the minor, insignificant price moves that occur in day to day trading of a security, the Zig Zag indicator ideally helps traders to avoid being fooled by temporary price moves into abandoning profitable positions and to stay focused on the overall trend that is in place.
The Zig Zag draws trendlines on charts which connect swing highs and swing lows, but only if such highs or lows represent a significant price movement as defined by the percentage move threshold set for the Zig Zag.
The chart below shows how the Zig Zag (the yellow line on the chart) does not react to any of the choppy, up and down, but ultimately insignificant trading that occurs around the middle of the chart, instead indicating a steady downtrend.
The following chart shows how the Zig Zag operates over time, reacting by drawing a new trendline only when there is significant price movement (in this case, a price change greater than 7%).
Some versions of the indicator allow analysts to set a minimum absolute price change movement rather than a percentage movement. For example, rather than setting the indicator at a 5% movement threshold level, it might be set to only react to a minimum price change in a stock of $20 or more.
The operation of the Zig Zag indicator is contingent on the type of chart it is applied to. It will operate based on closing prices when applied to line or dot charts, but on the whole price range of each time period plotted on bar charts or candlestick charts. There is likely to be more fluctuation in the Zig Zag – more trendlines drawn – using bar or candlestick charts, since they will reflect a wider price range than charts that only reflect the closing prices of each time period.
Because values for the Zig Zag indicator are plotted only after the close of each time period, and because the Zig Zag will only draw a permanent new line after price has moved significantly, it’s very much a lagging indicator.
It’s important when analyzing charts to know that the most recent Zig Zag line – the one showing on the far right hand side of a chart – may not be permanent. Whenever price changes direction, the Zig Zag will begin drawing a new line in that direction, but if the price movement ultimately fails to reach the Zig Zag’s designated threshold before moving back in the opposite direction, that temporary line will eventually disappear as the Zig Zag begins to draw a new line based on the most recent significant price movement.
For example, on the chart just above, at the point indicated by an arrow with the notation “moves less than 7% are ignored”, the Zig Zag indicator would have initially shown a temporary line being drawn upward along with the price move up indicated by the arrow, but because the 7% threshold wasn’t crossed and price subsequently turned back and made a substantial move to the downside, that temporary line would have disappeared, being replaced by the extended downside line showing on the chart that connects to the next swing low.
Therefore, the Zig Zag has very little use for traders or analysts attempting to predict future price movement. However, the swing highs and lows that the Zig Zag indicator identifies may represent future support or resistance levels, so to that extent it can be helpful to traders in spotting key price levels that may be control points for future trading.
The Zig Zag does sometimes reveal a major trend change to traders by virtue of the lines it draws marking out a well-known market reversal chart pattern such as the head and shoulders pattern. Even in a case like that traders would still need to augment such indications from the Zig Zag with traditional price action analysis, using technical indicators such as moving averages or candlestick patterns.
The important thing to keep in mind is the limited and specific purpose of the Zig Zag indicator – filtering out small, insignificant price fluctuations so that a trader looking at a chart can maintain their focus on the overall trend. For pinpointing trade entry and exit points traders will do better to use more traditional technical indicators applied to price action that are better suited to identifying market reversals, probable retracements, etc.