A common question we are often asked is how professional traders forecast the direction an asset will move in. This is a common question asked by people who are new to trading and those who have been following the finance industry closely.
Chart analysis is one of the common ways which Wall Street traders use to predict where an asset will move in.
In the past few months, we have been writing about charting and technical indicators. We have looked at indicators like the Relative Strength Index, momentum indicator, and the Bollinger Bands.
These tools are very popular and used by traders. Today we are going to look at a not-so-popular tool called Zig Zag Indicator.
What is the Zig Zag Indicator?
The Zig Zag indicator is a trading tool that connects significant bottoms and tops. The indicator is not so popular among traders, in fact, it is not provided as a default indicator in most trading platforms like the MetaTrader. As such, a trader must install it from the marketplace.
The process to do this is relatively simple: On the MetaTrader, just go to the code base, search for the Zig Zag, download it, and then apply it on the chart.
When you apply it, you will see a red line connecting tops and bottoms as shown on the chart below.
Example of Zig Zag Indicator
The Three Zig Zag Indicator Settings
This indicator has three settings. The default settings are usually the depth, deviation, and backstep. The default numbers of the three are 12, 5, and 3 respectively. As with all indicators, these numbers can be tweaked to suit your trading style. The numbers are also in percentages.
Changing the deviation will have an impact on the appearance of the Zig Zag line. For example, when you add the deviation, the lines will be spread relatively more. The chart below shows the same chart as above but with the deviation at 10.
What do these numbers mean?
The deviation is the minimum value of the number of points that is expressed as a percentage between the highs and lows of neighbouring candlesticks. This means that price actions that are less than 5% are ignored.
The depth is the minimum of the candles on which the zig zag will not make the maximum and minimum if the conditions of the first number are necessary for the construction to happen.
Finally, the backstep is the minimum number of candlesticks between highs and lows.
When you should include the Zig Zag Indicator in your Trading Strategy
The Zig Zag indicator is used for a number of reasons. Some of these reasons are:
Identifying tops and bottoms – The principle of the zig zag indicator is to identify significant swings. A top position is a position which tells time to short while a bottom is a position that tells time to short.
Elliot Wave Analysis – The Elliot Wave Analysis is an important technique that is used by traders. The principle is that the price of an asset moves in five motive waves and three corrective waves. The zig zag is an essential tool of identifying these positions.
Entry and exit points – The zig zag indicator is an important tool that can be used to identify entry and exit points.
Confirmation of trends – Zig Zag can also be used in combination with other indicators to identify and confirm trends.
How to Use it
There are several ways of using the zig zag indicator. The method we like is to use the indicator to find the buy and sell points when the asset is moving in a channel. This is done by first applying the indicator and then using the equidistance tool.
Alternatively, you can draw trend lines as shown on the chart below.
Trend Lines on zig zag
In this scenario, the goal is to buy when the price moves to the lower zig zag level and short when it moves to the upper lines.
Zig Zag and Elliot Wave
Another way of using the zig zag indicator is to use it to combine it with the Elliot Wave. This is a technique where the trader looks at the five impulse waves and applies them to the market. A good example of this is shown on the chart below. In this, the indicator can help you identify the areas to put the Elliot wave numbers.
The first wave is usually a small rally, followed by a dip and then a major rally. The rally is followed by a small dip and another short rally. While looking at these moves is easy, the Zig Zag indicator can help you identify then faster as shown below.
Using Zig Zag in Elliot Wave analysis
The Zig Zag indicator is also widely used in combination with other tools like the Fibonacci retracement and Andrews Pitchfork.
Summary
The zig zag is an indicator that many people don’t know. Yet, it is an indicator that can be very useful to you as a trader. You just need to read more about it and practice using the demo account.
You also need to know how to use it in addition to other indicators.
External useful Resources
- How to Use the Zig Zag Indicator to Locate Trends and Waves - Forexop.com
