Trading Systems

The Wyckoff theory and its

application in trading

Have you ever looked at the charts and thought to yourself that there are
patterns or cycles that keep repeating themselves but you find it hard to
decipher them? Have you ever found yourself searching for an entry but you
were unsure due to your biases? In this article, we will discuss the Wyckoff
theory which will introduce you to the concept of viewing the charts and
determining the current phase of the market.

History
Richard Demille Wyckoff was considered one of the five main pioneers of
technical analysis and the technical approach to studying the stock market in
the early 20th century. He got in touch with the industry at a very young age
and by the time he was in his 20s, he already became head of his own firm. He
was also a founder of The Magazine of Wall Street and throughout the years,
his efforts escalated in teaching the public about the concepts of smart
money and his perceptions of the rules in trading.

This article offers a summary of Wyckoff's theoretical and practical

approaches to the markets, along with tips on how to spot trade ideas and
execute long and short positions, analyze trading ranges of accumulation and
distribution, and use Point and Figure charts to pinpoint price targets.

Wyckoff Price Cycle

Wyckoff claims that by thoroughly analyzing supply and demand, which can
be determined by the price action, volume, and time, the market may be
understood and anticipated. He was able to determine the future intentions of
those powerful interests by studying the behavior of highly successful
individuals and groups that dominated particular issues because of the
access to information he had as a broker. He did this by using what he called
vertical (bar) and figure (Point and Figure) charts, however, nowadays thanks
to advanced technology, we can enjoy the luxury of the Japanese candlestick
chart that can portrays the same information as on the Point and Figure
charts. The image below shows an ideal scheme of how he imagined the big
interests planning and carrying out bull and bear markets.
Three Wyckoff Laws

Wyckoff's chart-based methodology is built on three core "rules" that have an

impact on a variety of analysis-related factors. These include identifying the
current and potential future directional bias of the market and individual
stocks, choosing the best stocks to trade long or short, determining whether a
stock is ready to exit a determined trading range, and extrapolating price
targets in a trend from a stock's trading range behavior. These laws guide the
evaluation of each chart and the choice of each stock for trading.

1. The direction of prices is determined by the law of supply and demand. The
foundation of Wyckoff's approach to trading and investing is based on this idea.
Prices increase when demand exceeds supply, and they decrease when supply
exceeds demand. By comparing price and volume bars over time, the trader or
analyst can examine how supply and demand are balanced. Although this law
appears straightforward, it takes a lot of effort to accurately assess supply and
demand on bar charts and comprehend the ramifications of supply and demand
patterns.
2. The law of cause and effect aids traders and investors in setting price objectives
by estimating the possible size of a trend that could emerge from a trading range.
In a Point and Figure chart, the horizontal point count represents Wyckoff's
"cause," and the price movements that match to the point count represent the
"effect." The force of accumulation or distribution inside a trading range, as well as
how this force manifests itself in a following trend or movement up or down, can
be regarded as the functioning of this law. A cause's impact can be estimated
 and measured using point and figure charts. (For an example of this rule, see
"Point and Figure Count Guide" below.)
3. The law of effort versus result gives an early indication of a potential trend
change that could occur soon. Divergences between price and volume can
indicate a shift in the trend of a price. After a significant rally, for instance, if there
are numerous high-volume (great effort) but narrow-range price bars, with the
price failing to reach a new high (little or no result), this could indicate that big
interests are selling shares in preparation for a trend change.

A Five-Step Approach to the Market

While selecting an entry or an instrument to trade, the method suggested by R.

Wyckoff can be summarized in this five-step approach. Although the
approaches were mainly applied in the stock market, they can be applied to
any market that involves institutional traders.

1. Determine the current state of the market and its possible future trend.
2. Select instruments in harmony with the trend.
3. Select instruments with a “cause” that equals or exceeds your minimum
objective.
4. Determine the markets’ readiness to move.
5. Time your commitment with a turn in the stock market index.

Analyses of Trading Ranges

Increasing market timing when taking a position in advance of a move where

there is a good reward/risk ratio is one goal of the Wyckoff approach. Trading
ranges (TRs) are areas where the prior trend (up or down) has stopped and
where supply and demand are relatively equal. Institutions and other powerful
professional groups gather (or distribute) shares within the TR as they get
ready for their subsequent bullish (or bearish) campaigns. “The Composite
Man” actively buys and sells in both accumulation and distribution TRs, with
the difference being that in accumulation, the number of shares bought
exceeds the number of shares sold, whilst in distribution, the opposite is true.
“The Composite Man”

According to Wyckoff, he mentioned in his theories “The Composite Man” as

“…all the fluctuations in the market and in all the various stocks should be
studied as if they were the result of one man’s operations. Let us call him the
Composite Man, who, in theory, sits behind the scenes and manipulates the
stocks to your disadvantage if you do not understand the game as he plays it;
and to your great profit if you do understand it.”

In other words, traders shall view the price movements in the markets as a
result of actions of one individual and advised further to try to approach the
markets the same as the composite man as he is the one who carefully plans,
execute and reflects his actions.

Accumulation: Events & Phases

PS stands for preliminary support, where after an extended downward trend,

significant buying starts to provide significant support. The price spread
widens and volume rises, indicating that the downtrend may be coming to a
finish.

SC stands for selling climax, the point at or close to which substantial or

panicked public selling is being absorbed by greater professional interests at
or near the bottom. This is the point at which widening spread and selling
pressure typically peak. In the SC, the price will frequently close considerably
off the low in order to reflect the major interests' buying.

AR stands for an automatic rally, which happens as a result of heavy selling

pressure. Prices are easily driven higher by a surge of purchasing, and this is
further exacerbated by short covering. This rally's high will aid in defining the
top limit of an accumulation TR.

ST stands for the secondary test, in which the price returns to the SC region to
evaluate the supply/demand equilibrium at these levels. As the market gets
closer to support in the vicinity of the SC, volume and price spread should
dramatically narrow if a bottom is to be confirmed. Multiple STs are frequent
after an SC.

Test: Throughout a TR (such as STs and springs) and at crucial junctures

throughout a price increase, large operators consistently conduct supply tests.
When significant supply shows up on a test, the market is frequently not ready
for a markup. A test or tests are frequently conducted after a spring; a
successful test (signifying that additional price rises will follow) typically
results in a higher low on lower volume.

SOS stands for the sign of strength which is defined as an increase in price
accompanied by a widening spread and comparatively higher volume. The
SOS frequently occurs following a spring, supporting the analyst's analysis of
that earlier move.

LPS stands for the last point of support, which is the bottom of a response or
pullback following an SOS. Backing up to an LPS entails a reversal to support
from resistance with a smaller spread and volume. Despite the seeming
singular precision of this phrase, there may be multiple LPSs on various charts.

BU stands for back-up. This phrase is a shortened version of a vivid metaphor

that Robert Evans, a pioneering Wyckoff method instructor from the 1930s to
the 1960s, coined. Evans compared the SOS to a "leap across the creek" of
price resistance, and the "back up to the creek" signified both a test for further
supply around the area of resistance and a short-term profit-taking strategy.
A back-up is a typical structural component that comes before a more
significant price markup. It can be a simple retreat or a new TR at a higher
level.
Springs or shakeouts typically happen late in a TR and give the stock's leading
players the opportunity to do a thorough assessment of the supply before a
markup campaign commences. A "spring" occurs when the price moves below
the TR's low and then turns around to close within it. This activity enables
powerful interests to deceive the public about the direction of the future trend
and to buy more shares at a discount.

The ability to foresee and accurately assess the direction and magnitude of
the move from a TR is essential for a Wyckoff analyst to succeed. Wyckoff,
fortunately, provides tested instructions for locating and defining the phases
and events inside a TR, which in turn provide as the foundation for calculating
price goals in the following trend. The following four schematics exemplify
these ideas: two show typical variations of accumulation TRs, followed by two
instances of distribution TRs.

Phase A signifies the end of the previous downward trend. Supply has
dominated up until this time. Preliminary support (PS) and a selling climax are
indicators of the impending reduction in supply (SC). On bar charts, where
increasing spread and high volume show the transfer of enormous numbers of
shares from the public to powerful professional interests, these occurrences
are frequently quite clear to see. An automatic rally (AR), which frequently
includes institutional demand for shares as well as short-covering, usually
follows the release of these strong selling pressures. Generally stopping at or
above the same price level as the SC, a successful secondary test (ST) in the
vicinity of the SC will exhibit less selling than earlier, a narrowing of the spread,
and decreased volume. One can expect new lows or a protracted period of
consolidation if the ST declines below the SC. The limits of the TR are
determined by the lows of the SC, ST, and AR as well as the high of the AR. To
help bring attention to market behavior, horizontal lines may be drawn, as
shown in the two Accumulation Schematics above.

Phase B performs the task of "creating a reason" for a fresh uptrend in

Wyckoffian analysis (see Wyckoff Law #2 - "Cause and Effect"). Institutions
and significant professional interests are stockpiling relatively inexpensive
merchandise during Phase B in preparation for the upcoming markup. The
process of institutional accumulation, which involves buying shares at lower
prices and using short sales to monitor price increases, can take a long time
(often a year or more). During Phase B, there are frequently several STs as well
as upthrust-like movements toward the upper end of the TR. In general, as the
TR develops, the major interests are net buyers of shares with the intention of
acquiring as much of the floating supply as they can.

Phase C: The "smart money" operators can determine whether the stock is
ready to be marked up during Phase C, when the stock price undergoes a
decisive test of the remaining supply. A price move below the TR's established
support level (formed in Phases A and B) that swiftly reverses and goes back
into the TR is known as a spring, as was previously mentioned. Because the
decline below support seems to indicate a continuation of the downturn, it is
an illustration of a bear trap. However, in actuality, this heralds the start of a
new rise, trapping the tardy sellers (bears).A successful test of supply,
symbolized by a spring (or shakeout) in Wyckoff's technique, presents a high-
probability trading opportunity. This is an excellent opportunity to start at
least a partial long position because a low-volume spring (or a low-volume
test of a shakeout) suggests that the stock is probably poised to move up.

The analysis is supported by the emergence of an SOS soon following a spring

or shakeout. However, as mentioned in Accumulation Schematic #2, the
testing of supply may take place further up in the TR without a spring or
shakeout; in this case, it may be difficult to identify Phase C.

Phase D: If our analysis is accurate, the constant dominance of demand over

supply should come as a result. A pattern of advances (SOSs) on widening
price gaps and rising volume, as well as reactions (LPSs) on narrower spreads
and declining volume, provides evidence for this. The price will rise at least to
the top of the TR during Phase D. In general, LPSs in this phase are great places
to start or extend profitable long investments.
Phase E: The stock departs the TR during Phase E, demand is fully in charge,
and everyone can see the markup. Setbacks, including shakeouts and more
common reactions, are typically temporary. At any time throughout Phase E,
new, higher-level TRs involving both profit-taking and the purchase of
additional shares (referred to as "re-accumulation") by significant operators
are possible. On the path to even higher price goals, these TRs are sometimes
referred to as "stepping stones."

Distribution: Events & Phases

Preliminary supply, or PSY, occurs when significant interests start to sell lots
of shares following a sharp upward trend. Volume increases and the price
spread widens, indicating the possibility of a trend change.

BC: buying climax, characterized by frequently significant rises in volume and

price spread. The intensity of purchasing peaks, with professional interests
filling heavy or urgent public demand at prices close to their peak. Since large
operators require enormous public demand to sell their shares without
reducing the stock price, a BC frequently occurs in conjunction with excellent
earnings reports or other positive news.

AR: Automatic reaction. After the BC, the strong buying significantly
decreased, but the heavy supply persisted, and an AR occurred. The lower
border of the distribution TR is defined in part by the selloff's low.
ST stands for the secondary test, in which the price returns to the BC region to
evaluate the demand/supply situation at the current price levels. Supply must
exceed demand for a top to be confirmed, so volume and spread should
decline as the price moves closer to BC's resistance zone. An ST could appear
as an upthrust (UT), in which case the price goes above the resistance
indicated by the BC and perhaps other STs before abruptly reversing to close
below resistance. Price frequently tests the TR's lower boundary after a UT.

SOW—sign of weakness. A downtrend to (or just barely past) the TR's lower
border, typically accompanied by an increase in spread and volume, is an
indication of weakness (SOW). The AR and the initial SOW(s) point to a shift in
the stock's price movement, with supply now in control.

Last point of supply, or LPSY. A weak rally on a tight spread following a test of
support on a SOW indicates that the market is having significant difficulties
advancing. Strong supply, low demand, or both may be to blame for this
market's inability to recover. Before markdowns start in earnest, LPSYs signify
the end of the demand cycle and the final distribution waves from large
operators.

Upthrust after distribution, or UTAD. The spring and terminal shakeout in the
accumulation TR have a distributional counterpart in the form of a UTAD. After
a breakthrough over TR resistance, it takes place in the latter stages of the TR
and offers a clear test of new demand. A UTAD is not a necessary structural
component, similar to springs and shakeouts: the TR in Distribution Schematic
#1 contains a UTAD, whereas the TR in Distribution Schematic #2 does not.
Phase A: In a distribution TR, Phase A denotes the end of the previous uptrend.
Demand has dominated the market up to this point, and preliminary supply
(PSY) and the buying climax are the first notable signs of supply entering the
market (BC). Following these occurrences, the BC typically undergoes a
secondary test (ST), frequently at a lower volume, as well as an automatic
reaction (AR). However, the uptrend may also come to an end without a
dramatic event, showing instead that demand has run its course as spread
and volume have shrunk; less upward movement is made on each rise until a
large amount of supply appears.

Phase B: The goal of Phase B is to establish a foundation in advance of a new

downward trend. Institutions and major business interests are currently
getting rid of their excess inventories and opening short positions in
preparation of the subsequent discount. The arguments for Phase B in
distribution are identical to those for Phase B in accumulation, with the
exception that as the TR develops, the large interests are net sellers of shares
in an effort to use up as much of the remaining demand as they can. These
actions leave traces that indicate the supply/demand balance has tipped
more in favor of supply than demand. For instance, spread and volume to the
downside typically increase dramatically in conjunction with SOWs.

Phase C: Phase C in distribution may be revealed by an upthrust (UT) or UTAD.

A spring's opposite is a UT, as was already mentioned. It is a price movement
that breaks above TR resistance before immediately turning around and
closing in the TR. The remaining demand is being examined in this. It is also a
bull trap because, despite appearing to indicate the continuation of the
upswing, it actually aims to "wrong-foot" uneducated break-out traders. Large
interests can deceive the public about the direction of a trend by using a UT or
UTAD, then sell more shares to break-out traders and investors at a premium
price before the markdown starts. A UTAD may moreover encourage smaller
traders with short holdings to cover and surrender their shares. A UTAD may
also persuade smaller traders with short positions to cover their positions and
hand over their shares to the larger interests behind the move.

Phase D: Phase D comes after Phase C's testing, which reveals the last signs of
demand. Price moves to or through TR support during Phase D. When a support
level is obviously broken or when the price declines below the midpoint of the
TR following a UT or UTAD, the evidence that supply is clearly in control
becomes more compelling. Within Phase D, there are frequently several weak
rallies; these LPSYs offer fantastic chances to start or grow winning short
positions. Phase D is dangerous for anyone who is still in a lengthy position.

Phase E: Phase E shows how the decline develops; the stock exits the TR and
supply is in charge. When a large SOW's TR support is broken, this breakdown
is frequently tested by a rally that fails at or around support. Additionally, this
gives a highly likely chance to sell short. During the markdown, subsequent
rallies are typically weak. Short position holders can follow their stops by
trailing them when the price falls. Climactic action may mark the start of an
accumulation or re-distribution TR after a major downtrend.

Supply and Demand Analysis

One of the main principles of the Wyckoff technique is the analysis of supply
and demand on bar charts through the study of volume and price fluctuations.
For instance, a price bar with broad spread, a high that is significantly higher
than the highs of the preceding few bars, and a greater-than-average volume
may indicate the existence of demand. The presence of supply is also
indicated by a high-volume price bar with a wide range and a low that is
significantly lower than the lows of earlier bars. These straightforward
illustrations conceal the complexity of such analysis's nuances and intricacies.
For example, correctly identifying and comprehending Wyckoff events and
phases in trading ranges, as well as determining when the price is prepared to
be marked up or down, depend greatly on supply and demand.

This fundamental strategy is embodied in the first and third laws of Wyckoff
(Supply and Demand and Effort versus Result), respectively. The conventional
wisdom of much technical analysis (and fundamental economic theory)
accepts one of the obvious insights of the law of supply and demand: price will
advance to a level where demand decreases and/or supply increases to
create a new (temporary) equilibrium when buy orders for shares exceed sell
orders at any time. The opposite is also true: if at any moment the number of
sell orders (supply) exceeds the number of buy orders (demand), equilibrium
will be (temporarily) restored by a price decrease to a level where supply and
demand are equal.

In order to predict probable turning points in price trends, Wyckoff's third law
(Effort versus Result) calls for the identification of price-volume convergences
and divergences. As an illustration, when the volume (effort) and price (result)
both rise significantly, they are in balance, indicating that Demand will
probably continue to drive price upward. However, there are times when
volume may grow, maybe even significantly, but price does not follow,
resulting in only a slight shift at the close. If we notice this price-volume trend
in response to support in an accumulation trading range, this suggests that
significant interests are absorbing supply, and is therefore positive. In a
distribution trading range, high volume on a rise with little price movement
indicates that there is strong supply from large institutions, which prevents the
stock from rallying.

Comparative Strength Analysis

Analysis of comparative strength was always a step in Wyckoff's stock picking

procedure. He sought stocks or industries that were outperforming the market,
both during trends and trading ranges, to find prospects for long positions, as
opposed to short positions, where he sought out underperformers. He
manually drew all of his charts, including bar and Point and Figure diagrams.
He, therefore, performed his comparative strength study by layering one chart
over another, as in the example below, to compare a stock to the market or to
others in the same industry. Wyckoff examined the strength or weakness of
each wave in respect to earlier waves on the same chart and to the
comparable points on the comparison chart when comparing successive
waves or swings in each chart. Finding important highs and lows and noting
them on both charts is a version of this strategy. The strength of the stock can
then be assessed by comparing its price to past highs or lows and repeating
this process on the comparison chart. Looking at the chart we may believe
that Wyckoff was purely trying to find correlations and at points where price
movement were not correlated, he would try to pursue a further research to
the insights of the caution to find possible under-valued stocks.
Final Word

By looking at the chart, we can certainly find the patterns and points explained
in the accumulation and distribution schematics as you can see in the
screenshot below.
Richard D. Wyckoff, one of the pioneers of technical analysis, who lived
approximately a century ago, supplied the public with some of the most
powerful insights and view on trading that helped him and other students
immerse profits. His legacy lives up to these days and many students across
the globe are familiar with his method which included ideas from other titans
of the technical analysis such as Charles H. Dow (a.k.a. Dow Theory) or Ralph
N. Elliott (Elliott Wave theory). There is no doubt that markets have particular
cycles that they go through and Wyckoff theory offers a simple and logical
viewpoint to the bigger picture of the cycle. Even though the chart patterns in
the accumulation/distribution phase are rarely respected, the definition of
each points perfectly make sense when analyzing the charts. In a combination
of supply/demand analysis and a comparative strength analysis, this method
makes the strategy to be one of the powerful tools in the market.

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