The Zig-Zag indicator is extremely useful for determining price trends, support and resistance areas, and classic chart patterns like head and shoulders, double bottoms and double tops. The Zig-Zag indicators uses both swing highs and swing lows in its calculation:
When a price (usually close) is both higher than the price previous to it and after it.
When a price is both lower than the price prior to it and lower than the price following it.
The Zig-Zag indicator can use both percentages or points in its construction. To construct the Zig-Zag indicator, there must be a certain percentage or number of points between a swing high and a swing low before a line will be drawn. The chart below of the E-mini Nasdaq 100 Futures contract visually illustrates the difference between a price retracement Zig-Zag of 3% and a price retracement Zig-Zag of 5%:
Notice how in the chart above that a Zig-Zag with a retracement percentage of 3% makes more distinct lines than the Zig-Zag with a retracement percentage of 5%. The purpose of using a Zig-Zag with a larger retracement percentage is to help eliminate price noise that is not significant for the trader’s analysis. As will be shown on the next page, the Zig-Zag indicator is extremely effective at uncovering stock cycles while screening out short-term price noise.