Zig-Zag Indicator – Useful for Filtering Out Market Noise

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Zig-Zag Indicator – Useful for Filtering Out Market Noise

Use the Zig-Zag to filter out market noise, and get a clearer view of market direction. The Zig-Zag isn’t really an indicator, as it isn’t going to give you trade signals. Rather, it simply makes your analysis easier. It can quickly show noteworthy corrections, as well as make Elliott Wave counting and finding Fibonacci Retracement and Extension points easier.

The easiest way to see how the Zig-Zag works is to apply it to a chart.

Figure 1. S&P 500 ETF with Zig-Zag (4%)

The Zig-Zag takes all the noise of the market and provides straight lines to connect high points and low points.

It does this by filtering out all price moves less than 4%, in this example. The % filter can be adjusted to any percent desired.

A 1% or 2% filter will draw more lines, since less information is being filtered out. This makes the Zig-Zag choppier, as shown in Figure 2.

Figure 2. S&P 500 ETF with Zig-Zag (2%)

If we increase the % filter then there will be fewer lines drawn, as the Zig-Zag will ignore all minor price moves and only connect significant highs with significant lows (significant for the time frame).

Figure 3. S&P 500 ETF with Zig-Zag (6%)

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While daily charts are used for the examples above, the Zig-Zag can be applied to any time frame. In addition to the % filter, some variations of the Zig-Zag also include an Average True Range (ATR) filter.

Aiding Elliott Wave Counts

Anyone who has used Elliott Wave knows that when you are starting out, getting rid of some of the noise can help. The Zig-Zag shows only the strong moves, and thus highlights impulse waves and corrections.

Unfortunately, you’ll still need to count the waves, and also realize when the Zig-Zag may have skipped over an important retracement (filter may need adjustment).

Elliott Wave analysis is beyond the scope of this article. For more on Elliott Wave, see Introduction to the Elliott Wave 5-3 Pattern.

Fibonacci Retracements and Extensions

A variation of the Zig-Zag, called the Zig-Zag Retrace, shows retracement and extension levels, relative to prior waves. This is similar to the Fibonacci Retracement and Extension indicators.

Common Fibonacci Retracements levels are: 23.6%, 38.2%, 50.0%, 61.8% and 78.6%.

Common Fibonacci Extension levels are: 61.8%, 100%, 138.2%, 161.8%, 200%, 238.2% and 261.8%.

Therefore, you can watch for these numbers to show up on the Zig-Zag Retrace.

Figure 4. S&P 500 ETF with Zig-Zag Retrace (4%)

Some of the waves have been labeled, so you can see how to read the numbers provided by the Zig-Zag Retrace.

Notice how if you would have been watching for Fibonacci levels, a number of these extensions and retracements reversed near the Fibonacci percentages listed above. Fibonacci numbers provide areas to watch, not exact entry signals. Therefore, this indicator would have be useful for automatically showing how far the market had extended or retraced, so you could then make your trading decisions and act on your signals.

The Zig-Zag and the Zig-Zag Retrace are not indicators typically used for providing trade signals. Rather they are analysis tools which filter out market noise, can be used on all time frames, aid in Elliott Wave Counting and can provide retracement and extension levels. The retracement and extension levels are useful when combined with traditional Fibonacci levels.

Trading Without Market Noise

Noise removal is one of the most important aspects of active trading. By employing noise-removal techniques, traders can avoid false signals and get a clearer picture of an overall trend. Here we take a look at different techniques for removing market noise and show you how they can be implemented to help you profit.

What Is Market Noise?

Market noise is simply all of the price data that distorts the picture of the underlying trend. This includes mostly small corrections and intraday volatility. To fully understand this concept, let’s take a look at two charts – one with noise and one with noise removed.

Before noise is removed:

After noise is removed:

Notice that, in Figure 2, there are no longer any areas in which the trend is not easily seen, whereas in Figure 1, it is often difficult to identify whether the trend is changing on some days. The technique used in this chart is averaging – that is, where the current candle factors in the average of prior candles in order to create a smoother trend. This is the aim of noise reduction: to clarify trend direction and strength.

Let’s take a look at how we can determine these two factors and combine them to create reliable charts that are easier to read.

Removing the noise to obtain a clearer perspective on the underlying trend can be an important step in executing a profitable trade. To learn more about developing your trading strategy, check out the Technical Analysis course at the Investopedia Academy, which includes video content and interactive examples to help you become a more effective trader.

Isolating Trend Direction

Isolating trend direction is best done through the use of specialized charts designed to eliminate minor corrections and deviations and only show larger trends. Some of the charts (such as Figure 2 above) simply average prices to create a smoother chart, while others completely recreate the chart by taking only trend-affecting moves into consideration.

Renko Charts

One example of a chart type that only uses trend-affecting moves is the Renko chart, named after the Japanese term renga (brick). Renko charts isolate trends by taking price into account but ignoring time.

They are created by using a simple three-step process:

  1. Choose a brick size. This is simply the minimum price change required for a new brick to appear.
  2. Compare the current day’s close with the high and low of the previous brick.
  3. If the closing price is higher or lower than the top of the previous brick by at least the size of one brick, one or more bricks are drawn in the next column in the respective direction.

Let’s take a look at an example:

As you can see, it is much easier to identify trends on these charts than on traditional candlestick charts. Further noise reduction can be obtained by increasing the size of the bricks; however, this will also increase the intra-trend volatility – make sure that you have enough capital to withstand this volatility.

Overall, Renko charts provide an excellent way to isolate trends, but they are limited by the fact that they don’t provide a way to determine trend strength other than simply looking at the trend length, which can be misleading. We’ll take a look at how to determine trend strength later.

Heikin-Ashi Charts

The second type of chart that can be used for noise reduction is the Heikin-Ashi chart. These charts use a strategy similar to the charts seen in Figures 1 and 2 – they factor in the current bar with an average of past bars in order to create a smoother trend. This process creates much smoother price patterns that are much easier to read.

These are the charts most commonly used when reducing market noise; they can easily be used with other indicators because they don’t factor out time. Another added benefit is that they also smooth out the indicator because the price bars are used as indicator inputs. This can help make indicators far easier to read.

Kagi Charts

Kagi charts are designed to show supply and demand through the use of thin and thick lines. New lines are created whenever a new high or low is established. By isolating highs and lows, it becomes much easier to see the larger trends.

Zig Zag Indicator Definition

What is the Zig Zag Indicator?

The Zig Zag indicator plots points on the chart whenever prices reverse by a percentage greater than a pre-chosen variable. Straight lines are then drawn, connecting these points. The indicator is used to help identify price trends. It eliminates random price fluctuations and attempts to show trend changes. 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; often 5%. By filtering minor price movements, the indicator makes trends easier to spot in all time frames.

Key Takeaways

  • Lowers noise levels, highlighting underlying trends higher and lower.
  • Works best in strongly trending markets.

The Formula for the Zig Zag Indicator Is:

How To Calculate the Zig Zag Indicator

  1. Choose a starting point (swing high or swing low).
  2. Choose % price movement.
  3. Identify next swing high or swing low that differs from the starting point = > % price movement.
  4. Draw trendline from starting point to new point.
  5. Identify next swing high or swing low that differs from the new point = > % price movement.
  6. Draw trendline.
  7. Repeat to most recent swing high or swing low.

What Does The Zig Zag Indicator Tell You?

The Zig Zag indicator is often used in conjunction with Elliot Wave Theory to determine the positioning of each wave in the overall cycle. Traders 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%. Stocks have their own patterns, so it is likely that traders will need to optimize the Zig Zag indicator’s percentage setting to suit those securities.

Although the Zig Zag indicator does not predict future trends, it helps to identify potential support and resistance zones between plotted swing highs and swing lows. Zig Zag lines can also reveal reversal patterns, i.e. double bottoms and head and shoulders tops. Traders can use popular technical indicators like relative strength index (RSI) and Stochastics oscillator to confirm the price of a security is overbought or oversold when the Zig Zag line changes direction.

A momentum investor might use the indicator to stay in a trade until the Zig Zag line confirms in the opposite direction. For example, if the investor holds a long position, they would not sell until the Zig Zag line turns downward.

Limitations of the Zig Zag Indicator

Like other trend-following indicators, buy and sell signals are based on past price history that may not be predictive of future price action. For example, the majority of a trend may have already happened when a Zig Zag line finally appears.

Traders should be aware the most recent Zig Zag line may not be permanent. When price changes direction, the indicator starts to draw a new line. 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.

Given the lag, many traders use the Zig Zag indicator to confirm the direction of the trend rather than attempting to time a perfect entry or exit. (For further reading, see: How do I use the Zig Zag Indicator to Create a Forex Trading Strategy?)

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