How to Use Zigzag Indicator Best Formula
What Is a Trend?
Zigzag Indicator Best Formula There is an annoyingly simplistic but essentially correct saying: “The trend is
your friend.” This saying immediately requires clarification on two points. The first
is to define a trend. The second is to understand that there are trends within trends.
There are intraday trends, daily trends, weekly trends, and monthly trends.
The theoretical definition of a trend is quite straightforward. In a rising trend
or a bull market, price is moving from the bottom left-hand corner of the chart
toward the top right-hand corner. In a declining trend or a bear market, the price
is moving from the top left-hand corner of the chart to the bottom right-hand
corner. However, because of trends within trends, you need to need to know what
duration of the chart you are looking at. The monthly chart sometimes, and for some
markets, may define a super trend, and it does so mostly for stock indexes,
financial instruments such as currencies and interest rates, and metals and petroleum.
These markets can establish a trend lasting for several years. Generally, the weekly
chart is more useful to futures traders for defining the major trend and, therefore,
for finding markets to trade or avoid. Zigzag Indicator Best Formula
For the successful futures trader, following a trend means buying a market that
shows, by going up, that it can go higher, and by selling a market that shows, by
going down, that it can go lower. In practice, the search for bigger and longer-lasting
trades requires as much agreement as possible between short- and long-term
trends. However, shorter-term trends should not have extended so far that the
market may be ready for a setback and possibly a sharp one. Within any major
trend, there can be, of course, severe retracements that do not violate the major
direction of the market. When there is a short-term downtrend within a long-term
uptrend, in all likelihood you should be buying, not selling, but only when the
short-term downtrend shows that it may be coming to an end, and the action of
price and the technical indicators are showing that the market can start to move up
again.
Upward and Downward Zigzags
An uptrend, or a bull market, has price making successively higher highs and
higher lows on the chart, on balance, and ideally doing so with reasonable regularity, in the form of an upward
zigzag. The more tenacious and regular the zigzag, in either direction, the more likely the trend is to continue, and
accordingly, the more confidence you can have in trading. This assumption is the
counterpart of the engineer’s principle that a trend in force is likely to remain in
force.
The chart for a declining market shows, on balance, a pattern of successively
lower highs and lower lows
When there is a pattern of erratic highs and lows, and particularly when they
occur between an identifiable ceiling and a corresponding floor, you have a sideways
or trading-range market—one with limited prospects for a worthwhile trade
until the price establishes an orderly zigzag up or down.
The way to see zigzags clearly is to use a line chart, one that joins the closing
price for each period to the next one instead of having vertical bars covering the
range for each period. Apart from showing the underlying and uncluttered direction of the market,
there is an additional reason for using a line chart as a tool for
designating a market’s direction. As with price-rule theory, discussed in Chapter 4,
the closing price is important. Many traders, and particularly floor traders, close
out some or all of their positions at the end of the day, week, or month, and some
will initiate new positions then, but only when conditions appear to be particularly favorable.
They shed the weak ones and may initiate or add to ones going in
the direction suggested by momentum. The closing price, whether at the end of a
day, a week, or a month, suggests, therefore, how much these traders, generally
representing money that is both substantial and smart, want to take their positions home in the expectation that the price will continue going their way when
the market reopens. Accordingly, the significance of the closing price increases
exponentially from the daily close through the weekly close to the monthly close.
W Formations: The Start of an Uptrend
Everyone loves to buy at the lowest possible price and sell as high as possible. The
the reward is often greater and the risk is usually lower, however, when you buy into
an established and strong bull market. Nevertheless, trying to get in on the ground
the floor of a possibly emerging bull market can be exciting when you get it right, so
it is worth knowing what to look for.
An uptrend, or a bull market, starts with a zigzag in the form of a W chart
Of course, there are many more W’s than there are valid new bull markets, and
you have to consider these formations in conjunction with other technical indicators described in later chapters. Also, the reliability of an emerging uptrend is
often proportional to the length of time it takes to develop. The longer the setup
for an upward move, the greater is the probability of a valid W formation, and the
farther the market is likely to go in due course.
The W formation that starts a trustworthy uptrend has an initial higher low that
holds above the previous low. Although it may be psychologically more difficult to
buy, a W formation is more bullish when the second low is significantly higher than
the first one. When a market has been going down for some time, it may require
several tests of the low to establish a springboard for higher prices. A successful
the third test down that holds above both the first and the second lows provides additional confirmation that the price may have stopped going down and, in addition,
that the line of least resistance now may be up.
To identify a W formation on the line chart:
1. Look for a low at 4 on the chart that is no lower than 2, and ideally is enough
above 2 so that there is no doubt that this new low really is higher.
2. A close above the close at 3 confirms the W. Once price has broken above 3
in the W formation, a retracement at least to the breakout level is so standard that you should not be concerned. This is normal price action.
Some technicians suggest buying only on this expected retracement. However, the
strongest markets never retrace, and you can never tell in advance which
these will be. The new upward zigzag remains in force as long as there is no
new closing below the previous zigzag low. A third test down, or more, that
holds above previous lows strengthens the interpretation that the market
has completed its business of going down and is set to go higher.
As with the principle of trends within trends, it often happens that there are
small W’s within bigger ones. There is also a general and reliable principle that the
longer a low holds, the more likely it is to provide durable support if it is tested
subsequently.
M Formations: The Start of a Downtrend
Many traders, particularly those with less experience, find it hard to believe in the
sustainability of a bull market, and this leads them to succumb to the siren call of
trying to sell prematurely, whether to close out long positions or to enter new short
positions. The risk of attempting to sell short into a market top is very high until there
are convincing indications of topping action. Foremost among these indications,
and for all practical purposes a prerequisite, is the M formation
Depending on the length of normal cycles in specific markets, an M formation
is exponentially more convincing on the monthly chart than on the weekly, which,
in turn, is more convincing than the daily, let alone an intraday chart.
To identify an M on the line chart:
1. Look for a downturn at the high at 4 on the chart that is below the one at 2.
2. A close below the one at 3 completes an M formation.
Reversing the pattern of an emerging bull market, there may be an upward
retracement back at least to the breakdown level before a more sustained decline
gets underway. Until there is a new bull market designation, don’t be fooled into
thinking that a retracement means that the market is now going higher after all.
There may be a retracement all the way back to the right-hand high of the M without
violating its validity. In a confirmed bear market, the price stops at that level, and
in a very weak market, it stops much below that level.
The Coiling Zigzag
Proceeding from the principle of upward and downward zigzags, it is additionally
useful to consider how they occur in two somewhat different but related varieties,
one for the coiling action within a consolidation, which also may be an intermediate
cyclical top or bottom formation, and one for a market in motion.
A significant market lows, zigzags sometimes develop with a double or triple
W, much like a coiling spring, prior to the actual breakout, and the concept is similar to rule 5, the Lindahl price rule (see ). The range from top to
bottom tends to be relatively small, and it is tempting to think that nothing significant is happening. However, the market shows its hand remarkably often when
there is a pattern of higher highs and higher lows within a small range. The more
developed the pattern is prior to the breakout, with more than just a couple of
tops and bottoms, the more likely it is that price will follow through when the
breakout occurs.
Equally important is that the line chart can suggest which way price is likely to
move out of consolidation within an apparent longer-term move. Some technicians hold that the probabilities are more favorable for a successful trade if you
wait for the breakout from a range before entering a new position. Certainly, this
is true when the price fluctuations within a consolidation are erratic, because then
the breakout may be in either direction. However, orderly coiling on the line chart
is a reliable predictive indicator, when it happens, and there can be a surging breakout like the action when you release a spring that has been compressed.
Often, therefore, the best way to trade coiling action within a consolidation may
be to enter an initial trade—say, half your normal commitment—as favorable
coiling is developing and then to add to the position when the breakout occurs
M’s,W’s, and Zigzags on the Cattle Chart
The daily line chart for June 2007 Live Cattle illustrates the concept of M’s, W’s,
and zigzags occurring as bigger waves and smaller waves.
In November, there was a straightforward M on completion of the lower high.
In the event, this market was not to develop any downside momentum, but this
does not negate the principle that this was a valid formation.
In December, a big W wave formed, with the right-hand bottom itself making
a textbook small W, above the arrow, from which, then, there was to be a worthwhile upward thrust. Then a large W formed, culminating in a W that then made
a third higher low, confirming the zigzag, marked with the line AB, with the last
upturn above the second arrow on the chart. In the event, this coiling was markedly
bullish, with each of the second and third lows significantly higher than the one
before. Here is an example of how steeper M’s and W’s may suggest more risk, but
in fact, the opposite is almost invariably the case.
How to Use Zigzags
1. To define a trend on a chart of any duration, you need at least an initial M
or W and, ideally, an established and regular zigzag
2. For trading decisions, the weekly chart normally defines the major trend,
although the daily chart alone may sometimes justify taking a trade.
For those markets having very long-term trends, look at the monthly chart
for additional confirmation, but don’t be deterred from trading if the
monthly chart has not yet fallen into line. Monthly charts are most useful
for markets that have long-lasting moves, such as the financials, metals, and
stock indexes. Agricultural markets tend to have shorter cycles, with trends
determined by the prospects from one harvest to the next or by stock breeding
cycles.
3. Occasionally, such as when a market has reached a clear and substantial barrier or when there is an island top or bottom, you might want to use an intraday chart, such as the 60-minute or the 120-minute, to use zigzags to make
a preemptive assumption of a trend reversal. This application is most valuable for those using day-trading techniques for potentially optimal new
entries or to ride a rebound from an obvious excess, as discussed in Chapters
22 and 23.
4. The signal for action occurs on completion of the time period generating
a turn A conflicting M or W or an established zigzag on the line chart—one in
the opposite direction to the way you want to trade—is a strong negative indicator when it is clear and completed, but it does not constitute an outright
embargo.
Normality is for there to be wobbles and conflicts. You might, for example,
consider a trade when there is a good zigzag on the weekly chart and on the
60-minute chart but not on the daily chart.
5. Market action negates a zigzag in a bull market with a closing price below
the previous low on the line chart or in a bear market with closing above
a previous high. When this happens, there is a strong exit signal from this
indicator, but not necessarily a compulsory one, on the duration of the chart
on which it occurs. An adverse close is exponentially more important on the
daily chart than it is on the 60-minute chart and more so again on the weekly
chart than on the daily chart.
6. A negated trend on the line chart does not connote a signal to trade in
the opposite direction. That requires completion of an equal and opposite
M or W.
7. Look for coiling action within consolidations—particularly when a market
is overbought—to sell or—oversold—to buy. A tight range in price does not
mean that there is limited potential as and when the price breaks out of the
range—on the contrary! Well-defined coiling action often permits a timely
entry at an excellent price relative to the risk.
8. In a strongly moving market, thrusts in the direction of the trend should take
price a long way, and retracements should give back little in price and last
only for a few bars.
9. M’s and W’s and established zigzags also apply to other indicators such as
moving average convergence/divergence (MACD)and stochastics, as discussed
in later chapters.
At the most trustworthy market turns, price and momentum indicators such
as stochastics both make simultaneous M’s and W’s and then zigzags, in the same
direction. When stochastics, a leading indicator, makes a higher second low and a
corresponding W, but the price makes a lower low, there is a so-called negative divergence. Similarly, there is a negative divergence when stochastics make a second
lower high but price does not. At the very least, negative divergence shows
flagging momentum and the potential for price to reverse direction. Action in
stochastics is more reliable than price action.
Zigzags in Gold
The monthly chart for gold from 1980 to 2006 shows clearly that there were four
extended periods of generally declining prices for gold from 1980 and two periods
when the price was rising strongly, with the bull market beginning in 2001 going
up dramatically. The regularity of these zigzags, both up and down, is almost
uncanny. The only period of real ambiguity during an established trend occurred
during the consolidation in the first nine months of 2005.
Notice the three-year sideways market from 1993 to 1996, when the price failed
to break higher and instead, after going inconclusively sideways, continued in due
course its downward extension. This decline occurred when the stock market generally and high-tech stocks, in particular, were going to the moon, and there seemed
to be no systemic risk and a corresponding need to own gold for insurance. Notice
to the two-year period between mid-1999 and mid-2001 when the price seemed
to stop going down and in due course began the huge new bull market. In the big
picture, there is a lopsided W, with a high made by a very powerful surge that failed
to follow through. On the retracement, however, the ground was given only grudging
until the low made in 1999 was tested and found good.
These periods of sideways market action illustrate the informal law that you
expect the price, when it breaks out of the consolidation, to make a substantial
move that is somewhat proportional to the length of time that is has been going
sideways. There is no way to calibrate this phenomenon mathematically in terms
of time and price, but this does nothing to diminish the validity of the principle.
While the move out of a long consolidation may be substantial, there is always the
challenge that there is no way to avoid getting stuck in some trades in markets
going sideways. Therefore, they are to be avoided unless the coiling action within
the range becomes unmistakable or until the breakout actually happens.
The weekly line chart for gold between 2004 and 2006 illustrates the point about
sideways markets, with their corresponding frustrations and also the potential
when the consolidation ends.
You see a persistent but much more ragged uptrend than you see on the
monthly chart—the weekly chart starts where the monthly chart shows the price
coming out of the dip and the apparent break of the zigzag in 2004.
The daily line chart for gold between November 2005 and July 2006 shows zigzag
theory working somewhat erratically and reflecting short-term technical damage
to the uptrend in February and March 2006, which is also evident on the weekly
chart as a distinct wrinkle.
Once the price broke higher in April, there was never a single aberration until
the eventual top. Once the market topped out and began a downward zigzag, there
was never an adverse zigzag until the violent decline ended. At the eventual top
of the market, the intraday price exceeded the intraday high at the market top in
September 1980 by just $3! The top in 1980 was itself $13 higher, with the M having
a gigantic dip in the middle.