The Zig Zag indicator filters out changes in an underlying plot (e.g., a security's price or another indicator) that are less than a specified amount. The Zig Zag indicator only shows significant changes.
The Zig Zag indicator is used primarily to help you see changes by punctuating the most significant reversals.
It is very important to understand that the last "leg" displayed in a Zig Zag chart can change based on changes in the underlying plot (e.g., prices). This is the only indicator in this book where a change in the security's price can change a previous value of the indicator. Since the Zig Zag indicator can adjust its values based on subsequent changes in the underlying plot, it has perfect hindsight into what prices have done. Please don't try to create a trading system based on the Zig Zag indicator--its hindsight is much better than its foresight!
In addition to identifying significant prices reversals, the Zig Zag indicator is also useful when doing Elliot Wave counts.
For additional information on the Zig Zag indicator, refer to Filtered Waves by Arthur Merrill.
The following chart shows the 8% Zig Zag indicator plotted on top of Mattel's bar chart.
The Zig Zag indicator is calculated by placing imaginary points on the chart when prices reverse by at least the specified amount. Straight lines are then drawn to connect these imaginary points.