Content
What is the Wyckoff method?
Wyckoff's three laws
Law of supply and demand
Law of Causation
The law of the relationship between effort and results
"Composite Man"
Accumulation (accumulation)
Momentum or uptrend
Distribution
Markdown (correction, downtrend)
Trading patterns using the Wyckoff method
Accumulation scheme
Distribution scheme
How effective is this trading technique?
Wyckoff's five-step approach
Conclusion
What is the Wyckoff method?
This trading method was developed by Richard Wyckoff in the early 1930s. It consists of a number of principles and strategies originally designed for traders and investors. Wyckoff devoted much of his life's experience to studying market behavior, and his work still influences much of modern technical analysis (TA). Nowadays, the Wyckoff method is applied to all types of financial markets, although it was originally focused only on stocks.
While creating his work, Wyckoff was inspired by the trading methods of other successful traders (especially Jesse L. Livermore). Today, he is held in the same esteem as other key figures such as Charles H. Dow and Ralph N. Elliott.
Richard has conducted a large amount of research which has led to the creation of several theories and trading methods. This article provides an overview of his work and includes:
Three fundamental laws;
The concept of “composite man”;
Methodology for analyzing charts (trading patterns using the Wyckoff method);
Five step approach.
In addition, Wyckoff developed special buy and sell tests, as well as a unique charting method based on points and figures (P&F). While tests help traders find the best time to enter, the P&F method is used to determine trading goals, however, we will not go into detail about these two topics in this article.
Wyckoff's three laws
Law of supply and demand
The first law states that the value of assets begins to rise when demand exceeds supply, and falls accordingly in the opposite order. This is one of the most basic principles in financial markets, which Wyckoff does not exclude in his works. We can represent the first law as three simple equations:
Demand > supply = price increases
Demand < supply = price falls
Demand = supply = no significant price change (low volatility)
In other words, Wyckoff's first law suggests that when demand exceeds supply, prices rise because there are more buyers than sellers. But in a situation where there are more sales than purchases, and supply exceeds demand, this indicates a further drop in value.
Many investors who use the Wyckoff method compare price movement to bar volume as a way to better visualize the relationship between supply and demand. This often helps predict future market movements.
Law of Causation
The second law states that differences between supply and demand are not a coincidence. Instead, they reflect preparatory actions resulting from certain events. In Wyckoff's terminology, a period of accumulation (cause) ultimately leads to an uptrend (effect). In turn, the distribution period (cause) provokes the development of a downward trend (effect).
Wyckoff used a unique technique of plotting figures on graphs to estimate potential effects for specific causes. In other words, he created methods for determining trading goals based on accumulation and distribution periods. This allowed him to assess the likely extension of the market trend after exiting the consolidation zone or trading range (TR).
The law of the relationship between effort and results
Wyckoff's Third Law states that changes in price are the result of overall effort, which is reflected in trading volume. In the case where the increase in the value of an asset corresponds to a high trading volume, there is a high probability that the trend will continue to move. But if the volumes are too small at a high price, the growth will most likely stop and the trend may change its direction.
For example, let's imagine that the Bitcoin market begins to consolidate with very high volume after a long bearish trend. High trading volumes indicate great effort, but sideways movement (low volatility) suggests little result. If a large number of Bitcoins change hands and the price does not fall significantly, this may indicate that the downtrend may be ending and there will be a reversal soon.
"Composite Man"
Wyckoff created the idea of a “composite man” (from the English composite man, composite operator), who embodies the imaginary personality of the market. He suggested that all investors and traders study the stock market from the perspective of if it were controlled by one entity, as this may make it easier for them to continue following trends.
At its core, the Composite Man represents major players (market makers), high net worth individuals, and institutional investors. This category of market participants always acts in their own interests, in order to ensure that they can purchase assets cheaper and sell them at a higher price.
The Composite Man's behavior was the opposite of most of the investors Wyckoff often observed, given their financial losses. But according to this technique, the composite person uses a somewhat predictable strategy from which investors can learn a useful lesson.
In this article, we will use the concept of the composite man to simplify the illustration of the market cycle. The cycle described in the Wyckoff method consists of four main phases: accumulation (accumulation), impulse or uptrend, distribution and markdown (correction, downtrend).
Accumulation (accumulation)
A composite person accumulates assets before most investors do. This phase is usually marked by lateral movement. Accumulation occurs in a gradual manner to avoid significant price changes.
Momentum or uptrend
Once the Composite Man owns enough shares, the moment the selling force is exhausted, he begins to push the market upward, creating an emerging trend that gradually attracts more and more new investors, which subsequently leads to an increase in demand.
It is worth noting that during an uptrend there may be several accumulation phases. They are also referred to as re-accumulation phases, when a strong trend stops for a while and consolidates before continuing its upward movement.
As the market moves up, other investors are encouraged to enter the market and buy assets. As a result, the unrest affects more and more people who want to take part. During such a period, demand is much higher than supply.
Distribution
The composite person then distributes the purchased assets. He begins to sell his profitable positions to those who enter the market at a later stage. Typically, the distribution phase is marked by a sideways movement that absorbs demand until it is exhausted.
Markdown (correction, downtrend)
Shortly after the distribution phase, the market begins to decline. In other words, after the composite person has completed selling a significant amount of his shares, he begins to push the market down. Eventually, supply becomes much greater than demand, and a downward trend is subsequently formed.
Just as during an uptrend, several phases of redistribution can occur during a downtrend. This is basically a short-term consolidation between large declines in the value of an asset. Declines can also overlap with dead cat jumps or so-called bull traps, where some buyers enter the market hoping for a trend reversal that won't actually happen. When the bearish trend ends, a new cycle of accumulation begins.
Trading patterns using the Wyckoff method
Accumulation and distribution schemes are the most popular part of Wyckoff's work, at least among the cryptocurrency community. This model breaks these two circuits into smaller sections of five phases (A through E), as well as several events, which are briefly described below.
Accumulation scheme
Phase A
The selling force decreases and the downtrend begins to slow down. This stage is usually marked by an increase in trading volume. Preliminary support (PS) indicates that new buyers are starting to appear, but this is still not enough to stop the downward movement.
A sales climax (from the English selling climax, abbreviated as SC) is formed through intense activity aimed at selling assets, as a result of which investors begin to capitulate. This often manifests itself as the highest point of volatility, with panic selling forming tall candles and wicks. A strong decline quickly turns into a surge, or automatic rally (AR), as buyers begin to absorb excess supply. Thus, the trading range (TR) of an accumulation pattern is defined as the distance between the minimum selling climax and the maximum of the automatic rally.
A secondary test (ST) occurs when a decline in market prices intersects with a selling climax (SC) area to test whether a downtrend has actually ended. In this case, trading volume and market volatility are usually lower than usual. While the second test often forms a higher low relative to the selling climax, it does not always go as planned.
Phase C
Based on Wyckoff's Law of Cause and Effect, phase B can be thought of as a cause that leads to a certain effect.
Phase B is the consolidation stage in which the composite person accumulates the largest amount of assets. At this stage, the market tends to test various levels of resistance and support within its trading range.
Numerous secondary tests (ST) may occur during Phase B. In some cases, they show higher highs (bull traps) and lows (bear traps) in relation to the selling climax and automatic rally, similar to phase A.
Phase C
This phase is a typical period of asset accumulation, also called spring. It is often the last bear trap before the market begins to make higher lows. During Phase C, the composite person makes a small offer and, in fact, those who should have sold their assets have already done so.
During the spring action, support levels begin to break through to stop traders and mislead investors. We can describe this as a last-ditch attempt to buy shares at a lower price before the uptrend begins. Thus, the bear trap encourages small investors to stop holding their assets.
However, in some cases, support levels can be maintained, and spring simply does not begin. In other words, there may be another accumulation pattern that includes slightly different elements, but not spring. However, the general structure of the scheme remains valid.
Phase D
Phase D represents the transition between cause and effect. It lies between the accumulation zone (phase C) and the breakout of the trading range (phase E).
Typically, during phase D there is a significant increase in trading volume and volatility. It usually involves last point support (LPS), showing a lower low before the market starts moving higher. The LPS often precedes a breakout of resistance levels, which in turn creates higher highs. This indicates the manifestation of signs of strength (from the English signs of strength, abbreviated SOS), since previous levels of resistance become new levels of support.
Despite the somewhat confusing terminology, there may be several last points of support during this phase. They often increase trading volume when testing new zones. In some cases, price may create a small consolidation area before effectively breaking through a larger trading range and entering the E phase.
Phase E
Phase E is the last stage in the accumulation scheme. It is marked by a clear breakout of the trading range, due to an increase in demand in the market, which indicates the beginning of an upward trend.
Distribution scheme
The distribution scheme works opposite to the accumulation scheme, with slightly different terminology.
Phase A
The first phase comes into play when the established uptrend begins to slow due to decreased demand. Preliminary supply (PSY) suggests that the selling force is still not strong enough to stop the upward movement. The culmination of purchasing power (from the English buying climax, abbreviated BC) is then formed through intensive asset purchases. This is usually caused by inexperienced traders who start buying on emotions.
The subsequent strong upward movement causes a chain reaction due to the absorption of excess demand by market makers. In other words, the composite person begins to allocate his assets to late buyers and the secondary test (ST) occurs when the market enters the buying climax, basically making a lower high.
Phase C
The distribution in phase B acts as a consolidation zone (cause) that precedes a downtrend (consequence). At this stage, the composite person gradually sells his assets, weakening and absorbing market demand.
Basically, the upper and lower levels of a trading range are tested multiple times, which can include short-term bearish and bullish traps. Sometimes the market may move above resistance due to the culmination of purchasing power, resulting in a secondary test in the form of an upthrust (UT).
Phase C
In some cases, the market exhibits only one final bull trap after a period of consolidation. This is also called UTAD (from the English upthrust after distribution) or upper springback after distribution, which is the opposite of accumulation (accumulation), during the action of the so-called spring.
Phase D
The distribution in phase D has many similar elements with a similar period of accumulation pattern. Basically it involves the last point of supply (LPSY) in the middle of the trading range, creating a lower high. From the moment this phase takes effect, new LPSY points begin to be created around or below the support zone. An obvious sign of weakness (from the English sign of weakness, abbreviated SOW) is a drop in value below support lines.
Phase E
The last stage of the distribution is marked by the beginning of a downward trend with an obvious breakout below the trading range, which is caused by the strong dominance of supply over demand.
How effective is this trading technique?
By its nature, the market does not always follow such trading patterns exactly. In practice, accumulation and distribution schemes can occur in different ways. For example, in some cases, phase B may last much longer than expected. For this reason, spring, UTAD and other tests may simply not be available.
However, Wyckoff's work offers a wide range of sound trading techniques that are based on numerous theories and principles. His work is certainly valuable to thousands of investors, traders and analysts around the world. The accumulation and distribution patterns described in this article can be useful for understanding the general order of cycles in financial markets.
Wyckoff's five-step approach
Wyckoff also developed a five-step approach to the market based on numerous principles and techniques. Simply put, this approach can be considered as a procedure for applying his work in practice.
Step one: identify the current trend.
The primary task is to determine the current trend and make a superficial assumption about where and how far it can go, which raises the following questions: “what is the current trend?”, “what is the relationship between supply and demand?”
Step two: determine the strength of the asset.
How strong is the asset relative to the market? Does its value move with the market or opposite to it?
Step three: find an asset with a reason to continue to grow.
Are there enough reasons to take a position? Is the reason compelling enough that the future potential benefit (consequence) justifies the potential risks?
Step four: determine the probability of price growth.
Is the asset ready for the expected movement? What is its position relative to the current trend? Are the price and trading volume commensurate with the possible growth? This step often includes Wyckoff tests for buying and selling the selected asset.
Step five: time your entry.
The last step contains all the timing information. For the most part, this involves analyzing stocks to compare their performance with the underlying market.
For example, a trader might compare a stock's price performance relative to the S&P 500 Index. Depending on the asset's position within a customized Wyckoff trading framework, this analysis can provide insight into future price movements. Ultimately, this makes it easier to find a favorable position to enter the market.
It is worth noting that this method is best suited for assets that move with the market or index. However, in the cryptocurrency market, such a correlation may not always be present.
Conclusion
Almost a hundred years have passed since the publication of the work, but the Wyckoff method is still in demand to this day. It is certainly much more than just a technical analysis indicator as it includes many principles, theories and trading techniques.
At its core, the Wyckoff Method allows investors to make smarter, more logical decisions without relying on their emotional state. His extensive work provides traders and investors with a range of tools to reduce risk and increase their chances of success. However, there is no single foolproof technique when it comes to investing. You should always approach all transactions with caution and consider all potential risks, especially in the highly volatile cryptocurrency market.