The Wyckoff Method Explained

Technical analysis, a trading strategy that works to predict the price movement of assets in a financial market, dates back to the 18th century. Principles in technical analysis often work by studying past data on the price of an asset to determine profitable entry and exit points.

Over time, many theories in technical analysis have developed, with some historical ones being left behind, for reasons of relevance. Nevertheless, some theories have shifted and been adapted to modern financial markets, such as cryptocurrency.

The Wyckoff Method, developed in the 20th century, is a technical analysis principle still used by traders to guide decisions regarding investment and trading. This article explores the Wyckoff method’s rules, concepts, and schematics. The article also explores the application of the Wyckoff method to the cryptocurrency market.

Where did the Wyckoff Method come from?

The Wyckoff method originates from the teachings of Richard D. Wyckoff, a stock market trader in the early 1900s. Wyckoff started trading the stock market at a young age and had so much success in his career that he opened a brokerage firm at a young age.

When Wyckoff was invested in the stock market, many legendary stock operators, such as JP Morgan and Charles Dow, came out with their thoughts on the stock market. Wyckoff noted most of their practices and applied them to his investment and trading strategy. He observed an injustice in the system between retail traders and big corporations and decided to act positively on his observation by educating the less informed. He founded an institution now known as the Stock Market Institute, where he promulgated several trading theories of technical analysis.

His teachings have now been put together into what is known as the Wyckoff Method. Although designed to analyze the stock market, Wyckoff’s method has since been applied to other financial markets.

What is the Wyckoff Method?

The Wyckoff Method is a term used to refer to a series of technical analysis-based laws and principles that guide investors and traders in decision-making for successful stock market trading.

Created by Richard D. Wyckoff in the 1930s, the Wyckoff Method or approach consists of rules based on his observation and experience working as a stock market broker. Wyckoff’s teachings include fundamental principles guiding the stock market, comments on market cycles, elements in price trend development, and schematics for analyzing market charts.

The Three Laws of the Wyckoff Method

The execution of Wyckoff’s teachings in the technical analysis depended on three fundamental laws. According to Wyckoff, these laws are significant enough to affect many sides of analysis and decide the future of a market or an individual stock. The three rules of the Wyckoff method provide information that serves as guides in selecting the perfect asset for trading or deciding when to trade long or short positions.

The Law of Supply and Demand

Wyckoff’s law of supply and demand represents one of the most fundamental concepts in finance and economics. The law provides that the price action of an asset is dependent on changes in supply and demand. The consequence of this principle can be represented in three formulas as follows:

• Demand > Supply: Increased price
• Demand < Supply: Reduced price
• Demand = Supply: Little to no change in price (low volatility)

According to Wyckoff’s principle, a bullish trend is created when more people buy than sell, thus hiking the market demand over supply. Conversely, where people are selling more than buying, demand falls, and supply rises, causing a price drop.

This principle is usually applied by considering volume data and comparing it to price action. By understanding the relationship between supply and demand for the current market, traders can come up with insight into the upcoming market directions.

The Law of Cause and Effect

Wyckoff’s second law pertains to the differences in supply and demand. The law of Cause and Effect argues that there is an underlying logic to the differences in supply and demand.

The principle provides that mass trading action results in disparities in supply and demand. A market period dominated by buying (accumulation) will result in a rise in demand, raised prices, and ultimately bring about an uptrend. Conversely, where the market is collectively selling (distribution), there will be an increase in supply, thereby causing the reduced prices that are apparent in a downtrend.

Wyckoff applied this principle in predicting how long a market trend would last after a period of consolidation.

The Law of Effort vs. Result

Wyckoff’s third law proposes that the trading volume should represent changes in the price of an asset. The law of effort vs. result posits that where the trading volume does not reflect the price action of an asset, there exists a variation in the market trend. This means that when an asset’s trading volume and price action are in harmony, the market trend is a dominant one and is likely to continue. Conversely, if there are differences between the volume and price action, the trend will likely end soon or reverse.

Wyckoff’s Theory on the Market Cycle

In his book Studies in Tape Reading, Richard D Wyckoff, creator of the Wyckoff method, proposed a theory on the market cycle. From his studies of supply and demand, Wyckoff deduced that markets moved in a cyclical pattern comprising four phases. This theory explains the price action movement of stocks and other securities, allowing traders to identify the direction of a market and predict reversals.

According to Wyckoff, the four phases of a market cycle are Accumulation, Markup, Distribution, and Markdown.

Accumulation

The first stage of the market cycle is characterized by sideways price movement. At this stage, the big players in the market buy in carefully and skillfully at a rate small enough to avoid attention. As more and more traders develop an interest in the market, the trading range features higher lows, with prices preparing to push higher. As the bulls of the market assume power, prices break through the upper level of the trading range, establishing a consistent uptrend.

Markup

The consistent uptrend established at the end of the accumulation phase persists here. Less experienced traders and investors have caught wind of the opportunity and are starting to buy in, driving the demand up and prices higher. Some experienced traders might exit their positions having made considerable trends during the uptrend. During the Markup phase, there may be multiple shorter phases of accumulation, otherwise known as re-accumulation. Where this occurs, the larger uptrend somewhat pauses and moves sideways before picking up again and continuing on its uptrend.

Distribution

Once the price action fails to set new highs, the distribution phase is said to have begun. As the former uptrend loses momentum and the market moves into a sideways range, traders and investors start to sell off their assets. Less experienced investors, in hopes of a new uptrend, will continue to acquire the asset. Price action during this phase marks lower tops and higher lows, signaling a market trend reversal.

Markdown

The last stage of the Wyckoff Market Cycle kicks off with a downtrend. As the bearish trend gains traction, traders and investors rush to close their positions. The bearish phase is said to be established when the prices fall past the previously established lows of the distribution phase. The markdown phase ends when the base signals the start of a new accumulation phase.

Analyzing Trading Ranges using the Wyckoff Method

The Wyckoff method is most helpful in making timely decisions as regards a trading position. One thing a financial analyst must take note of when trading using the Wyckoff method is Trading Ranges. Trading ranges refer to the time after the halt of a market trend during which the market experiences relative equilibrium between demand and supply.

During a trading range, institutional players in the market sell or buy their assets in preparation for the next trend (bearish or bullish).

The most useful skill of a financial analyst applying the Wyckoff Method is making accurate speculations on the direction and magnitude of the move out of a trading range. Wyckoff, in his teachings, provided some guidelines for identifying the different phases and events that occur during a trading range. These guidelines also help to speculate on price targets in the incoming trend.

Wyckoff’s guidelines are outlined in four schematics: The first two being the events and phases in the accumulation phase of the market cycle and the last two outlining the events and phases of the distribution phase.

Wyckoff Accumulation Schematics: Events

In the accumulation schematic, the trading range exists between Preliminary Support and Back Up events. The accumulation phase sees the price action moving mostly sideways before an upward trend. The events of the accumulation phase are as follows:

Preliminary Support (PS)

This is the first event of the accumulation phase. It occurs after a long bearish trend. For the first time in the stretch of the prior bear trend, the market is experiencing pronounced support. The volume of the asset increases as well as a widening of the price spread, pointing to the fact that the bear trend is approaching a halt.

Selling Climax (SC)

The selling climax comes after the PS event, with a significant price drop miming the prior bear trend. It features heavy or panicked selling, and the price closes off very low in a long candlestick.

Automatic Rally (AR)

At this point, the selling pressure from the SC is close to non-existent, and a small wave of buying eases the price upwards. Short sellers often dominate this event, covering their positions. The high of the Automatic Rally determines the high of the accumulation trading range.

Secondary Test (ST)

At this stage, the price of the asset revisits the low set by the selling climax at a controlled stage. This movement is characterized by higher volumes and price spread.

Spring

This event features a hard test of concurrent lows that often mislead traders and investors. Some traders will, unfortunately, judge the spring as a bearish trend and lunch into selling. This will swing the price into an up-and-down pattern. The spring ends with a shakeout (which is like spring but more rapid).

Sign of Strength (SOS)

The price advances at an increasing speed, supported by a relatively higher volume. Usually, this event occurs after spring to confirm an interpretation of the prior market action. Otherwise, SOS occurs after the last point of support.

Last Point of Support (LPS)

This is the final pullback in the accumulation phase before the buildup for a bullish trend. On some charts, LPS occurs more than once despite the finality of the name used to describe the term.

Wyckoff Events and Phases Basics.

Source: StockCharts.com

Wyckoff Accumulation Schematics: Phases

According to Wyckoff’s market cycle, the accumulation phase features sideways price movement alongside appearances of the Wyckoff events. Wyckoff’s accumulation schematics outline the phases as follows:

Phase A

The first phase in the accumulation phase kickoffs just as the prior downtrend ends. Before this phase, supply dominated the market more than demand, and prices reflected this. As supply starts to climb down, Wyckoff events Preliminary Support and Selling Climax occur, signaling the beginning of the accumulation phase. The PS and SC will be apparent to analysts on a trading chart where heavy volumes can be spotted due to the significant asset transfer from the public to the more powerful players in the market.

As the selling pressure settles, an AR will occur with wide demand for the asset from institutional players and short-sell traders. An ST closes off the phase to show less selling and a decreased volume.

Phase B

According to Wyckoff’s law of cause and effect, phase B can be referred to as the cause that leads to an impact represented by the upcoming uptrend. At this phase, more large players are building interest in the market. Phase B is a consolidation phase featuring varying levels of resistance and support. The phase usually features multiple STs, but the price swings are wide and accompanied by a high volume.

Eventually, the supply begins to balance out with demand, and the volume reduces, signaling the onset of phase C.

Phase C

In this phase, the spring occurs, putting the asset through a decisive test of the remaining supply. During the spring, the price moves below the support level established in the previous two phases and back into the TR. The spring has been described as the last bear trap before the price starts to climb. If spring’s test on supply is successful, it represents a high trading opportunity, which is soon validated by the appearance of an SOS.

Phase D

At this stage, the market is transitioning between Cause to Effect as it is the last phase before the market breaks out in Phase E. Usually, Phase D features increased trading volume and volatility.

The price will also move to the top of the TR. The Last point of support often occurs at this stage, although it may occur more than once. All the LPS exist as good points to enter a long position.

Phase E

At the final phase of the accumulation stage, the stock leaves the TR and begins its ascent for the uptrend. Demand dominates the market with short lives set, backs, and shakeouts.

Crypto Trading Using Wyckoff Accumulation Theory

In some cases, a Wyckoff accumulation theory application will not lead to a big price rally in the cryptocurrency market.

It may be beneficial to trade crypto using the Wyckoff method to employ a range-bound strategy to profit from fluctuations in the Accumulation phase’s TR. By opening a long position at the bounce of the ST, some profit can be made at the AR level. As a precaution, traders could place a stop loss order below the ST level, avoiding more significant losses if there is a false breakout.

For traders more serious about long positions, the safer option is to look for confirmation of Wyckoff’s signals in fundamental catalysts concerning the crypto asset.

For example, a Bitcoin Wyckoff accumulation setup ranging from May 2021 and November 2021 produced a price rally that took the price from $37,000 to $69,000 at the end of the breakout in Phase E.

Bitcoin’s Wyckoff Accumulation Setup May 2021- November 2021

Source: Trading View

Traders without a high-risk appetite may wait until Phase D of the Wyckoff setup to buy in. Once the price has broken past the SOS position, they may enter a long position. Subsequently, it is still advisable to place a stop loss order below the SOS to cut losses in the case of a reversal.

Conclusion

The Wyckoff method, which was developed over 100 years ago, is very effective for traders who want to catch the core part of a trend. However, the theory’s application has expanded beyond the stock market and technical analysis over time.

A trader’s chances of making profitable trades increase if they are well-versed in all aspects of the Wyckoff method. Technical analysis and cryptocurrency trading in general necessitate caution, extensive research, and close market monitoring. It is recommended that traders be wary of risks and arm themselves with knowledge of other technical analysis strategies and tools.