There are a few legends who contributed immensely to the development of technical analysis by developing technical analysis, principles, theories, laws, and insights into the markets.
The most popular ones are Dow, Elliot, Gann, and, of course, Wyckoff, who codified the techniques used by Livermore and other top traders of his time into trading principles and laws.
Born 1873, Richard Demille Wyckoff worked as a stock runner for a New York brokerage firm in his teenage years, and in his 20s, he founded his own brokerage firm.
He also established The Magazine of Wall Street, which he managed for nearly two decades. During those years, he observed and interviewed legendary traders, like Jesse Livermore, JP Morgan, and others, and used all he gathered to develop many theories and laws about trading, which we are about to discuss in this post.
The Wyckoff Trading Method: the three laws
Wyckoff based his methodology on three fundamental laws that involve many elements of technical analysis, such as gauging the present and potential future directional tendency of the markets, identifying the different stages of the market and knowing when a market is about to transition from one stage to another, choosing the best market to trade, and estimating how far the market may go after breaking out of a range.
The three laws of Wyckoff include:
- The law of demand and supply
- The law of cause and effect
- The law of effort and result
The law of demand and supply
This principle determines the direction of the price and is central to the Wyckoff trading method. The law states that when the demand is greater than supply, the price rises, and when the supply is greater than demand, the price falls. Going further, when the demand matches supply, there is no significant price movement.
The law can be reduced these simple equations:
It is one of the primary principles of economics, and it pretty much works in every aspect of life, not just the financial market. When there is more demand for any goods than its supply, the price of that goods goes up because of increased buying pressure, and when the demand drops lower than the supply, the price falls.
In the financial trading world, the bulls represent the demand, while the bears represent the supply. To evaluate the balance between demand and supply, traders often compare price movements and volume bars over time.
The law of cause and effect
Wyckoff’s second law implies that when there is a difference between demand and supply, it doesn’t just occur by chance. Rather, it is the effect of periods of preparation in the market. Wyckoff called those periods accumulation and distribution. He believes that accumulation is the cause of an uptrend, while distribution is the cause of a downtrend.
The principle can be used to estimate how far a trend can move after the price breaks out of a trading range or consolidation.
Wyckoff used the Point and Figure chart to demonstrate the relationship between a potential effect and the cause. The horizontal point count in the Point and Figure chart represents the cause, while the vertical distance the price moves per point count corresponds to the effect.
Traders can use the principle to define potential targets based on the time the price spends in accumulation or distribution. The longer the accumulation or distribution, the greater would be the trend that follows afterward.
The law of effort and result
This law states that every effort in the market should bring a corresponding result, and effort, here, represents the trading volume. A huge trading volume (the effort) is expected to bring a big price move (the result). If that does not happen, the price move may be getting exhausted and may be about to change direction.
For instance, if, during a rally, the price is failing to make a new high when the volume is increasing, it could be that the big boys are unloading their positions in anticipation of a change in trend.
It can also be the other way — a big price move with a small volume indicates a false move, and the price may be about to change direction. This can happen when the price breaks above a range with a small volume. It will likely fail and head downwards, creating a bull trap (upthrust).
The Wyckoff Trading Method: the composite man
In trying to explain how the price moves in phases, Wyckoff proposed the idea of the Composite Man (or Composite Operator) — an imaginary entity that controls how the price moves.
In the other words, the Composite Man represents the big players, such as institutional traders, wealthy individuals, and market makers, who have what it takes to manipulate the market so that he can buy low and sell high.
Wyckoff believed that the Composite Man behaves differently from most retail traders and that most retail traders lose money because they trade in the opposite direction to the Composite Man.
So, he suggested that retail traders should try and play the game the way the Composite Man plays by following his footprints, which, interestingly, he (Wyckoff) believed should be easy to spot since the Composite Man plays the market in a predictable pattern.
Hence, it doesn’t matter whether the market moves are caused by normal buying and selling activities by the public or artificial manipulations by the big players, a retail trader should always try to trade in the direction where the Composite Operator intents to move the market.
Wyckoff’s teaching about the composite man can be summarized as follows:
The Wyckoff Trading Method: the market cycle
Based on the supposed trading activity of the Composite Man, Wyckoff formulated a market theory, which is still being used in the financial market today. The theory states that the price moves in cycles of four phases:
Accumulation phase
This is the first phase of the market cycle, according to Wyckoff. It occurs after a prolonged downtrend and marks a period when the big players are busy accumulating their positions.
They build their positions gradually without tipping their hand so as to prevent the price from changing significantly.
In other words, institutional traders have stopped selling and started buying while the retail traders are still selling in their numbers, thinking that the preceding downtrend will still continue.
On the chart, you will probably see a ranging market or bullish reversal chart patterns, such as an inverse head and shoulder or triple bottom pattern.
It is possible that the price may start making higher swing lows, but on many occasions, the price will break below the lower boundary of the range and reverse, creating a false breakdown (spring).
The false breakdown happens when the institutional traders deliberately push the price lower to lure in more sellers so that they can quickly fill up their orders before pushing the price up.
Most times, the false breakdown happens with a low volume, showing that there was no serious “effort” (remember the third law) for the move. What happens next is that the price reverses and breaks out of the upper border to start a new uptrend.
Uptrend / Markup phase
The second phase, the uptrend or markup phase, starts with the price breaking out of the upper border of the accumulation region.
It shows that the bulls, which, in this case, are the institutional traders, are ready to overcome the resistance posed by the retail sellers and push the price higher.
Most times, the price bar that caused the breakout and other subsequent price bars are associated with high volume.
What results, is the emergence of a new bullish trend. As the price moves higher, the stop loss orders of retail sellers get triggered, fueling the upswing.
On seeing a new uptrend, most of those sellers turn to buyers, and the retail traders on the sidelines also jump into the market.
As the price is ascending, there are occasional pullbacks, which often occur with lower volume. Each of those pullbacks creates an opportunity to enter the market.
Distribution phase
The third phase of the market cycle, the distribution phase, is characterized by reduced volatility and to and fro price movements — a ranging market.
Bearish chart patterns like the head and shoulder and triple bottom pattern can also be seen as the distribution phase, as there is a failure of the price to make a sustainable higher high.
During this phase, the institutional traders are gradually unloading their position, while some are shorting the market.
However, the retail traders are still carried away by the preceding uptrend and continue to buy, taking the opposite end of the institutional traders’ sell orders.
One thing the big players do here is that they don’t let the price drop until they have finished unloading their positions.
In fact, they may even push the price a bit higher than the upper border of the range market to lure in more buyers to take their positions.
This temporary breakout usually fails, creating a bull trap. What mostly follows is a downward breakout of the lower border.
Downtrend/markdown phase
The last phase of the market cycle is the downtrend or markdown. It starts with the breakdown of the lower border of the distribution phase and the emergence of a new downtrend.
It shows that the institutional traders, most of whom are in short positions by now, have decided to let the price drop.
With the price dropping lower, retail buyers are changing to selling positions, and traders on the sidelines are jumping in with market sell orders — all these trigger a selling frenzy that makes the price drop faster. What you get is a downtrend, after which a new cycle begins with another accumulation phase.
The Wyckoff Trading Method: the five-step approach to trading the markets
Whether your interest is in the stock market or the forex market, the Wyckoff trading method involves a five-step approach to analyzing the markets, choosing the one to trade, and making your trades. The steps can be summarized as follows:
Determine where the market is at the moment and project its future trend
You have to determine the stage of the market — accumulation, uptrend, distribution, or downtrend.
Not always easy to know for sure, but at least, you can identify the market structure. Is the market trending or in a range? If in a range, which direction does your demand and supply analysis indicate that the price will go in the near future?
You can do your analysis on any chart, but, if you can, also analyze the point and figure chart. Your analysis would help you decide whether to trade at all and, if so, which position to trade.
Select an instrument that is in harmony with the broad market trend
Whether you are trading the stock, commodity, or forex market, you have to compare the instrument you want to trade with a broad index of that particular market. If the broad market is in an uptrend, be sure you choose the one that shows stronger strength that the general market. If the broad market is in a downtrend, choose an instrument that is weaker than the general market.
The relative strength indicator can help here. If you are trading the USD-denominated currency pair, you can compare the pair with the USD index or its inverse.
Choose an instrument with a “cause” that equals or exceeds your minimum objective
One of the Wyckoff’s laws is the Cause and Effect, which shows how a price target (effect) can be estimated from the cause (accumulation/distribution), especially when using Point and Figure (P&F) chart — where the horizontal P&F count in a trading range represents the cause, and the price movement shows the effect.
So, when selecting an instrument, choose the one that has built enough cause (accumulation) to meet your projected upside target in the case of a long position or the one that has enough distribution to meet a downside target.
Determine the instrument’s readiness to move
For a market that is in an accumulation or distribution phase, study the trading range to determine the readiness of the market to move into a trend. Volume analysis and checking for the presence of a spring pattern (in the accumulation phase) or a bull’s trap (in the distribution phase) can help.
For the accumulation phase, if the downswings, including the spring, occur on low volume while the upswings occur on high volume, watch out for an upward breakout and the emergence of a new downtrend.
Time your trades with a turn in the broad market index
In any market, there tends to be a correlation in the way the various instruments move, so most of the time, individual instruments move in harmony with the general market. If you time your trades to coincide with the emergence of a new trend in the broad market index, it will increase the odds of success. You can also use volume analysis to anticipate when the market is about to turn to further improve your timing.
The Wyckoff Trading Method: how to apply it in your trading
The main idea of the Wyckoff trading method is to recognize each stage of the market cycle and know what next to expect in the market, which then guides the position you take.
For instance, if the market is in the accumulation phase, you watch for the breakout of the upper border of the trading range, which is the beginning of the uptrend phase, to take a long position.
On the other hand, if the market is in the distribution phase, you wait for the breakdown of the lower border of the trading range to enter a short position and ride down the emerging downtrend. Whatever position you take, aim to hold it as close to the end of the trend as possible — make sure you have a clear trading plan though.
-Trade entry: You want to enter when the price breaks out of the accumulation or distribution phase. Confirm whether the phase is accumulation or distribution by looking at the previous price movements and look for the appropriate breakout.
Also, the presence of a spring pattern shows that you are dealing with accumulation, while the presence of a bulls’ trap all but confirms distribution. Chart patterns can also help. Do your volume analysis to know when a breakout is likely. Enter long when the price breaks above the accumulation region, and go short when the price breaks below the distribution region.
-Stop loss: If you are going long at the beginning of the markup phase, place your stop loss order below the lowest point of the accumulation region. For a short trade at the beginning of a markdown phase, place your stop loss order above the highest point of the distribution region.
-Profit target: You can do Wyckoff’s analysis on the Point and Figure chart to estimate the potential target if you can do that. Alternatively, look for features of the distribution phase to get out of a long position or the features of an accumulation phase to get out of a short position.
The Wyckoff Trading Method: an example
The chart above is that of Brent Crude Oil on the weekly timeframe. You can see the markup phase on the left, which started in 2009 and continued until 2011. This phase was followed by the distribution phase, which lasted until the last quarter of 2014. The price dropped very fast during the Markdown phase, and it was almost completed by the end of 2014, giving way for the accumulation phase.
The accumulation phase lasted between 2015 and 2017. You can see that it took the form of an inverse head and shoulder pattern. The price broke above the neckline of the chart pattern, starting a new markup phase, but the uptrend failed as the price fell below the lowest point of the accumulation zone.
The Wyckoff Trading Method: the drawbacks
The Wyckoff trading method may seem like a clear and simple concept to understand and use in trading, but when trying to put it into practical use, you will realize how difficult it is to implement.
One of the first challenges you will encounter is how to differentiate a temporary consolidation in an uptrend or downtrend from a potentially trend-reversing distribution or accumulation phase.
Another drawback is that not many people are used to the Point and Figure chart, so it may be difficult to effectively apply the law of cause and effect in projecting the expected price movement. Moreover, the volume spread analysis doesn’t always follow the way Wyckoff explained it, and spring and upthrust patterns may not occur.
As a result of these drawbacks, new traders may find it difficult to master. In addition, even experienced traders cannot apply it in short timeframes.
Final words
The Wyckoff trading method consists of laws, theories, and trading techniques developed by one of the legends of technical analysis, Richard Demille Wyckoff. The methods are centered on the different stages of the market cycle and how the major market players exploit the various stages to their advantage. It is left for the retail traders to identify the activities of the big players and try to follow in their footsteps.