The Indicator Series: Following the Markets with The Zig-Zag Indicator

On my indicator series of posts, I explore the nature and mathematical definition of indicators and attempt to give some guidance into how the different indicators can be used for the creation of trading systems. Today I will be talking about a very popular indicator which many people have attempted to use to create “holy grails”, the indicator we will be exploring today is called the “zig-zag”. Through the next few paragraphs you will learn how the zig-zag indicator is calculated, what it tells you, what it doesn’t tell you and how it might be used for the creation of likely long term profitable automated trading tactics.

The zig-zag indicator has a very clear objective: to let you have a clearer perspective about price action and the meaningful quality of retracements and trending movements. This indicator is built upon the simple principle of pseudo fractal formations and the notion that only movements between them higher than a certain percentage value of the instrument’s value are worth considering. The zig zag is drawn by locating a pseudo fractal formation of either a high or a low where the two bars around the high and low are both lower and higher respectively. The picture below shows some examples of pseudo fractal formations used for the drawing of the zig zag indicator.

After these pseudo fractals are located we then join each fractal with the next one by a line if and only if the difference between both fractals is higher than a given set percentage. For example if your threshold was 3% you would only draw a line between both fractals if the change between both was higher than 3% of the instrument’s value. This means that the indicator is adapted against the instrument as it increases or decreases in value, something which makes it more adaptive than many indicators as the relative meaning of retracements or continuations remains constant.

The zig-zag indicator, shown below, helps you see trend continuation and reversals which are meaningful according to your set criteria. However since the formation of a pseudo fractal is required for the formation of a new line only values of the zig zag on the third bar in the past can be considered “static” while newer values can “change” as the market evolves since pseudo fractals can be formed or disappear as bar is painted. However there are a few versions of the zig zag indicator which only draw the lines up to the point where they are certain, this are the so called “no repaint” versions of the zig-zag indicator which are exactly like regular implementations with the first few bars removed for further clarity.

The zig-zag is a potentially useful indicator since it makes retracement and trend continuation formations clearer than with a simple glimpse at the chart since it automatically eliminates movements which are below the cut off threshold within the indicator. There are several ways in which the zig-zag indicator can be used but most of them include the entering of trends upon retracements or the use of support and resistance levels (assumed as zig-zag repeated inflection values) to trade. However since the definition of the levels takes time you need to learn how to lead the indicator through a deep understanding of its meaning.

For example after the formation of a new high point it becomes clear that you are now in a retracement (per the pseudo fractal definition) and therefore this might be considered a good place to enter a new trade towards the upside. Things such as the difference between the tip of the pseudo fractals and the current point can be considered to enter trades either in a continuation or reversal sense since it will measure the amount of momentum the market has to offer against the prevailing previous movement.

However one thing which must be VERY clear is that the zig-zag is NOT showing you anything which is not already on your screen and prone to interpretation with a simple glimpse and line drawing. The zig-zag is merely a tool to help you have clearer mathematical definitions – when building algorithmic strategies – or a clearer sight when trading manually but it is by no means a foreteller of future price values. In order to succeed with the zig-zag – as with any other indicator – you need to understand how the indicator is built and what it is telling you, you need to act based on the consequences of current zig-zag formations instead of attempting to enter based just on the notion that the zig-zag will yield some sort of magical prediction power (which it doesn’t have). Many people love the zig-zag because it allows them to see something they didn’t see before but it is very important to understand that the information shown has ALWAYS been there on the charts and that the zig zag merely represents the same information in a filtered fashion. The successful use of the zig-zag requires judicious interpretation and knowledge of what the different movements are telling you about where price is headed.

If you would like to learn more about my work in automated trading and how you too can learn how to create and use automated trading systems based on sound strategies please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)

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