Zig Zag Indicator Trading Strategy — What Is It? (Backtest And Example)
Last Updated on October 23, 2022
There are many technical indicators out there that are not frequently used in everyday trading but can be useful for analyzing previous price actions to easily spot useful patterns and trends. One of such tools is the Zig Zag indicator.
The Zig Zag indicator is a basic tool that analysts use to analyze the price action of a security to spot trends and patterns. It helps in spotting price swing points which act as support and resistance areas, and thus, helps in filtering out irrelevant price swings or fluctuations that may constitute noise at best. However, the indicator may not be useful in real-time trading, as it lags a lot and repaints.
At the end of this article we tried to make a useful Zig Zag indicator strategy. The indicator is far from easy to backtest, and it is also pretty unlikely to work well in live trading due to its backward-looking bias.
Want to learn more about this indicator? Read along!
What is the Zig Zag indicator?
The Zig Zag indicator is a basic tool that analysts use to analyze the price action of a security to spot trends and patterns. It helps in spotting price swing points which act as support and resistance areas, and thus, helps in filtering out irrelevant price swings or fluctuations that may constitute noise at best.
Since it can be used to identify support and resistance price levels in a market, the indicator is often employed with Elliott Wave Analysis to help identify the beginning and end of each wave. By determining the support and resistance areas, it helps to identify significant changes in price while filtering out short-term fluctuations. This helps to show the price waves that should be counted when performing the Elliot Wave Analysis. It is a good trading indicator for any trader who follows indicators that use swing highs and swing lows.
The purpose of the Zig Zag indicator
The Zig Zag indicator is good only for analyzing historical data to spot existing patterns and trends. It is not predictive in any way — only based on hindsight. While it can delineate key past price swings of securities, it cannot be used to forecast the next swing highs and swing lows.
However, in as much as the indicator is not predictive, it is still very useful, as it can be used in many ways, such as counting Elliott waves, where it is often used to determine the positioning of each wave in the overall cycle. It also shows the important historical highs and lows you can use to draw lines to identify Fibonacci projections and retracements. Moreover, it makes chart patterns such as double bottoms, double tops, and head and shoulders easy to be identified.
In essence, its ability to filter out insignificant price swings that occur within an overall trend is important to analysts. The Zig Zag indicator creates swing lines on a chart, which can be used to identify price trends. It eliminates random price fluctuations and attempts to show trend changes. By filtering minor price movements, the indicator makes trends easier to spot in all time frames.
The indicator is designed to help traders maintain a profitable market position throughout a sustained trend. The Zig Zag lines only appear when there is a price movement between a swing high and a swing low that is greater than a specified percentage — which is usually 5%. This price movement threshold helps traders avoid being fooled by minor, insignificant price fluctuations so they can stay focused on the overall trend.
Traders can also combine it with popular technical indicators, such as the relative strength index (RSI) and the stochastics oscillator, to confirm whether the price of a security is overbought or oversold when the Zig Zag line changes direction.
How the Zig Zag indicator works
The Zig Zag indicator works by plotting points on the price chart whenever prices reverse by a percentage greater than a pre-set value. It then draws straight lines to connect these points. The points and lines are adjusted only when price movement above a pre-set value occurs.
The default value on most versions of the indicator is 5%. With that setting, the Zig Zag indicator will not mark any fluctuation in price that is less than 5%. However, you can, of course, set your own minimum percentage values for the indicator.
Many traders use values between 5% and 10%. You can experiment with different percentage settings to see what gives the best results. For example, a setting of 4% may define waves more clearly than a setting of 5%. Since stocks have their own patterns, you may need to optimize the Zig Zag indicator’s percentage setting to suit whichever stock you are analyzing.
How is Zig Zag calculated?
You don’t need to manually calculate the Zig Zag indicator yourself, as the trading platform (we use Amibroker in this article) will plot the indicator for you. But if you want to know how the indicator is calculated, here are the steps:
- Choose the % price movement you consider significant for a price swing.
- Select a starting point — a swing high or swing low.
- Identify the next swing high or swing low from the starting point that is greater than or equal to % price movement.
- Draw a trendline from starting point to new point.
- Identify the next swing high or swing low from the new point that is greater than or equal to % price movement and draw a trendline.
- Repeat to the most recent swing high or swing low and continue like that for subsequent swing points
Note that once a % price movement has been set, smaller price swings are eliminated and won’t be indicated. Normally, closing prices are used, but other price points, such as the high or low, can also be used.
How the Zig Zag indicator appears on the chart
The way the Zig Zag indicator displays on the chart depends on the type of chart it is applied to. When applied to a line chart or dot chart, it automatically plots with closing prices. But if it is applied to a bar chart or candlestick chart, you can choose the price point (close, high, low, or even open) it plots with. When other price points apart from the closing prices are used, there is likely to be more of the Zig Zag lines when using a bar or candlestick chart since they will show a wider range of prices than charts that only use closing prices.
Below is a candlestick chart that shows the Zig Zag plotted on the high/low prices:
Zig Zag indicator examples
The Zig Zag indicator shows the various price swings. It delineates the individual swings with lines drawn from the swing highs and swing lows.
The chart below has a setting of 5% price movements:
When the % threshold is increased to 8%, it shows bigger swings and ignores the smaller ones. See the chart below:
The indicator becomes even more selective when you change the depth setting, as in the chart below:
Limitations of the Zig Zag indicator
As with most other trend-following indicators, the Zig Zag indicator is meant to analyze historical price action, and as such, may not be predictive of future price action. For instance, before a Zig Zag line marks a swing point, the price has left the swing point and the next price move may have almost completed. Because values for the Zig Zag indicator are plotted only after the close of each time period (thus after the fact) and it only draws a permanent new line after the price has moved significantly, it tends to be very much a lagging indicator.
Another problem is that the most recent Zig Zag line — the one showing on the far right-hand side of a chart — may not be permanent, as the indicator redraws the line if the price continues to move in the other direction. That is, when the price changes direction, the indicator starts to draw a new line, but if that line does not reach the indicator’s percentage setting and the price of the security reverses direction, the line is removed and replaced by an extended Zig Zag line in the trend’s original direction.
For example, on the chart below, the points indicated by a black arrow were ignored because they are not up to 8%. The Zig Zag indicator would initially show a temporary line being drawn upward along with the movement of price. However, when the 8% threshold wasn’t crossed and the price subsequently turned back to the downside, that temporary line was moved to show an extended downside line connecting to the next swing low. Check out the last price swing down (blue arrow). The Zig Zag line there is being moved to continue an upswing, but the indicator is still not sure if the next swing is downward.
So, while the indicator may look good on the chart in hindsight, it is not useful for real-time trading, as the indicator is even more confused than the trader in reading price swings.
Who invented the Zig Zag indicator?
The Zig Zag indicator was originally discovered by an S&P 500 trader named Bill Wolfe, who used it to track his Wolfe Waves. The Wolfe waves work a bit like Elliot Waves, but there are some differences in charting techniques. Wolfe waves are made up of five waves showing supply and demand towards an equilibrium price.
Zig Zag indicator trading strategy
Let’s go on to backtest one or many Zig Zag indicator trading strategies.
But let’s wait. Is the indicator useful for backtesting? Unfortunately, no. It requires extreme caution.
The Zig-zag indicator, as well as other many other functions and indicators, look into the future. Because of this you need to “delay” the trading signal to make sure you are not “looking into the future” and thus making your backtest utterly worthless for real trading. We can assure you many traders have been fooled by many a Zig Zag indicator trading strategy!
To better illustrate the problems without having a delay, we can look at this chart in Amibroker showing all 5% moves:
In the bottom of April 2020 the Zig Zag indicator rises almost continuously, a lot more than 5%, but have very few retracements. Thus, the indicator almost shows a straight line. This is why the Zig Zag indicator is often useless for backtesting! It needs a move in the opposite direction to make a reference point.
Because of this, we choose not to do any backtests. No Zig Zag indicator trading strategy is likely to hold up well in trading and out-of-sample backtesting!