The Wyckoff Trading Method -Full Tutorial

What is the Wyckoff Method?

Developed in the early 1930s by Richard Wyckoff, this method is a combination of principles and chart schematics that aim to identify the market structure and forecast power trends in the early stages. The Wyckoff method can be applied to every financial market.

Starting by the 3 fundamental Wyckoff laws, an analysis of the 4 phases of the market, detailed accumulation/distribution schematics, and finally, the 5-step method.

 

MODERN TRADING USING THE WYCKOFF METHOD

 

Wyckoff Three Laws

Three fundamental laws provide support to Wyckoff's principles:

(1) Demand & Supply Law

The basic concept behind every economic theory. Price should rise if demand is greater than supply, and decline if supply is greater than demand. Moreover, when demand and supply are found in equilibrium the price should remain unchanged.

The law of Demand & Supply is unbreakable in the long run. Nonetheless, in short periods, it might be invalidated, especially if volume shrinks. That is why according to Wyckoff price action should always be combined with volume bars. Nowadays, sophisticated traders analyze demand/supply by using also the OrderBook.

(2) Cause & Effect Law

This is one of the fundamental laws of the astronomical universe. For every effect, there is a definite cause, and for every cause, there is a definite effect. According to Wyckoff, price action is not a random event, price action is the effect of a particular cause. Therefore, the price changes as a result of specific events. Based on the phases of accumulation and distribution, traders can make reliable predictions about future price action.

In Wyckoff's basic chart, there are two consolidation periods that provide the cause for the price to change in the future (effect):

• accumulation is the cause of an upcoming uptrend (effect)

• distribution is the cause of an upcoming downtrend (effect)

By using a simple chart, traders can measure a cause (Accumulation/Distribution) and count the extent of its effect (Uptrend/Downtrend).

(3) Effort vs Result Law

The third law links price action (result) with volume (effort). The price changes as a result of a specific effort, this effort can be measured by analyzing the trading volume.

• If price action and volume are found in perfect harmony, there is an already established price trend and there is a high probability that this trend will continue

• If price action and volume are found in random order, there is a high probability that the trend will consolidate, or even reverse

Divergences between price action and volume create tricky market conditions. For instance, a price breakout above a key resistance should be confirmed by a significant increase in volume. If the price breaks key resistance and volume remain unchanged, there is a high probability that the price will soon retrace below resistance. This situation is described as a fakeout. Besides, key market tops or bottoms should be confirmed by significant volume.

 

 

The Composite Operator -A Contrarian Approach to the Market

This is a very interesting point of view. Wyckoff recommended that investors should see the market as there is a single entity that controls it. That entity is called a 'Composite Operator' and theoretically includes brokers, investment banks, hedge funds, investment firms, and very large retail traders.

The Composite Operator represents smart money that needs significant liquidity to enter the market. Financial trading is a zero-sum game, and as a few people are making a lot of money, there are also a lot of others who are losing money. If a single entity controls the market, it has a strong incentive to move the market against the herd. This is a particularly useful point of view for traders to adopt a contrarian culture, as they should.

 

The Four (4) Phases of the Market Cycle

According to Wyckoff, the Composite Operator applies a predictable strategy that creates a repeating market cycle consisting of four phases:

1. Accumulation Phase (consolidation)

2. Uptrend Phase (mark-up)

3. Downtrend (mark-down)

4. Distribution Phase (consolidation)

(i) Accumulation Phase

The accumulation phase commences after the strong downtrend of a financial asset. The asset is now trading below its ‘fair value’ and the Composite Operator buys the market in anticipation of a future uptrend. The Composite Operator aims to buy at a ‘fair’ price and needs time to accomplish it. Consequently, the accumulation phase follows a sideways market structure. In other words, there is no specific trend, and price range, between two general boundaries.

• The trading range’s bottom is near where the previous trend has been halted

• The trading range’s upper boundary (top) is determined by the initial rally (Automatic Rally). However, there are instances, that the top is near 61.8% of the previous top (Fibonacci level)

• Volume is a key determinant of the beginning and the completion of the Accumulation Phase

• The accumulation phase can be observed in any timeframe, but it becomes reliable on H4 and above timeframes, even better on Daily and above

(ii) Uptrend Phase

As the Composite Man has bought enough, he pushes the price higher, and the second phase commences. The price breaks key resistance and volume booms. Retail traders start to enter the market, however, technical indicators suggest that the market is overbought. Most retail traders are afraid to enter long positions by anticipating an imminent correction. However, the price continues to rise without a major correction, and finally, everybody is buying the market. As the market tops, the Composite Man is now a careful seller.

• During the uptrend, there can be re-accumulation phases, where the trend stops and consolidates. These phases are called bear traps. A re-accumulation period is a bullish event as it signifies that the market has a long way to go.

(iii) Distribution Phase

The market has already topped, and the Composite Operator continues to sell. On the contrary, retail traders are aggressively buying as the mass media extensively cover the market. The Composite Operator slowly distributes his holdings to the masses. The market is moving sideways.

(iv) Downtrend Phase

As the distribution phase completes, the market starts moving downwards. The Composite Operator sells what is left. The downtrend is already established but retail traders anticipate that the market will soon reverse to the upside, therefore, they are still holding, or even buying more.

• The technical indicators signal oversold market levels, and which confuses retail traders furthermore

• The downtrend may include re-distribution periods, these periods are called bull traps or else Dead Cat Bounces

• A re-distribution period is a bearish event as it signifies that the market has a long way to go

When the downtrend is complete a new market cycle starts with a new accumulation phase.

 

ACCUMULATION SCHEMATICS

These are some key points of the accumulation phase, according to Wyckoff. Note that volume should increase on rallies and diminish during pullbacks. This is one of Wyckoff’s buying tests for accumulation.

Chart: Wyckoff’s Accumulation Schematics (EURUSD)

PHASE-A

• PS -Preliminary Support, the Composite Operator starts to buy the market, however, the downtrend is not yet complete. Volatility and volume are significantly increasing.

• SC -Selling Climax, volatility, and volume boom as retail investors sell in panic. The price bottoms and that price level will later become the lower boundary of the accumulation’s trading range.

• AR -Automatic Rally, the downtrend is now complete. The selling pressure is weaker and the Composite Operator continues to buy the market, therefore, there is a strong rebound. Depending on the extent of the previous downtrend, the early rallies can move the price up to 100%. The highs of this early rally determine the upper boundary of the upcoming trading range.

• ST -Secondary Test, the Composite Operator stops buying and even takes some profits, the price revisits the bottom to test the dynamics of supply. Retail traders are now anticipating lower lows and thus they are selling everything. As the price bottoms for the second time, volatility and volume are significantly diminishing.

PHASE-B:

The second phase is characterized by moderate volatility and tight volume. The price is ranging between the highs of the early rally (AR) and the lows of the secondary test (ST). The Composite Operator is a careful buyer while the majority of retail traders are mainly bearish.

• RULE: As mentioned before, the volume should increase on rallies and diminish during pullbacks.

PHASE-C:

The Composite Operator tests the remaining supply by shaking the price.

• SPRING: The “spring” period misleads retail traders who believe a price breakdown and a lower-low are imminent.

• Test— The Composite Operator tests the price for the last time. Nevertheless, if there is a considerable amount of supply, the market is not ready to take off, and another test may be on the way.

PHASE-D:

The fourth phase of accumulation is very bullish. Most indicators are showing highly overbought market levels and that makes a lot of traders wait for a correction before entering long positions.

• SOS -Sign of Strength, the market finally breaks out of the previous range, volatility, and volume booms.

• LPS -Last Point of Support, a price pullback after an SOS. Usually, the previous resistance acts as support.

PHASE-E:

The price aggressively moves up, heading for a market top. Now retail traders start building their long positions. Market tops should be confirmed by record volumes.

 

 

DISTRIBUTION SCHEMATICS

These are the key points of distribution according to Wyckoff:

Chart: Wyckoff’s Distribution Schematics

PHASE-A:

The Phase-A of distribution is a continuation of Phase-E of accumulation.

• PSY -Preliminary Supply, the Composite Operator is now a seller. The PSY is where he starts to unload. However, retail traders are significantly bullish and the market continues to move up. The volume shows signs of expansion.

• BC -Buying Climax, retail traders buy in panic anticipating a huge rally. However, the Composite Operator sells aggressively, and the market tops. At this exact point, good news may be released. The volume tops, even close to record highs.

• AR — automatic reaction, as there is a lot of supply but no new demand, the price breaks to the downside. Depending on the extent of the previous uptrend, this automatic reaction can be quite brutal. Volume is lower than BC, but it is still significant.

• ST -Secondary Test, the price makes a final attempt to create a new high. Volatility and volume decrease as the price approaches the point of BC.

PHASE-B:

• SOW -Sign of Weakness, as the market fails to form new high, price tanks, but it eventually finds support close to AR. The volume is still decreasing.

PHASE-C:

This is the opposite SPRING period of the accumulation phase. The Composite Operator tests the remaining demand.

• UT -UpThrust, the market attempts to form a new high, and that misleads retail traders who believe a rally is imminent. Many retail traders open leveraged positions that are liquidated in a short while.

This attempt (UT) may happen earlier, in Phase-B, and Phase C may solely include an LPSY.

PHASE-D:

As the Composite Operator continues to sell, the price breaks down the previous range. Volume and volatility increase. There might be a correction to the upside where previous support acts as resistance. This correction is called a bear market rally or a bull-trap.

• LPSY — Last Point of Supply, LPSY is the point representing the exhaustion of demand. Now, the Composite Operator knows it is time to unload the remaining supply at any price.

PHASE-E:

The last phase is characterized by a fast price drop, limited volatility, and limited volume.

• Test: There might be another test to the upside, mainly aiming at the liquidation of leveraged short positions (short-squeeze).

 

The Five-Step Method of Wyckoff

According to Wyckoff, these are the five steps for efficient market analysis and good decision-making:

(1) Analyze the trend and the dynamics of demand/supply by using volume bars.

(2) Select assets in the same direction as the trend. Analyze how these assets have performed in the past during strong market trends. If you are not sure about the trend don’t trade the market.

(3) Select assets in an accumulation phase if you trade long, and in the distribution phase, if you trade short. Determine if the potential reward of trading these assets is strong enough to justify the risk of holding them.

(4) Evaluate the asset’s readiness to commence a trend using volume to confirm the completion of the accumulation/distribution phase.

(5) Time your entries/exit in the market by using the general index. Position yourself in the market by recognizing the current phase of the general market:

• The general Stock Market Index, when trading shares

• The US Dollar Index, when trading Forex currencies

• The Total Market Cap Index, when trading cryptocurrencies

 

RESOURCES:

• Richard D. Wyckoff  -The Richard D. Wyckoff Method of Trading and Investing in Stocks: A Course of Instruction in Stock Market Science and Technique

• Hank Pruden -The Three Skills of Top Trading: Behavioral Systems Building, Pattern Recognition, and Mental State Management (2007)

 

■ The Wyckoff Trading Method -Full Tutorial

George M. Protonotarios,

for TradingCenter.org (C)