Almost a century ago, Richard Wyckoff, the mind behind the concept, developed the Wyckoff Method in the early 1930s. This theory comprises a full set of principles, approach, and strategies that provides crucial information to traders about price action. It is a Smart Money Concept that gives insights into the Institutional buying and selling of financial instruments. Initially, the Wyckoff Method was focused only on stocks but is now put in application to all financial markets whether it is Forex, Indices, Metals, or Cryptocurrencies.
In order to grasp this theory, this blog will give an overview about the following concepts and techniques put forth by Richard Wyckoff:
- The three fundamental laws
- The Composite Man
- Wyckoff Schematics
- A five-step approach to the Market
Three fundamental laws
Let us now quickly dive into the Three fundamental laws.
First is The Law of Demand and Supply:
This is the fundamental concept in Economics and the principle follows in the financial markets which are that prices rise when demand is greater than supply, and prices fall when Supply is greater than Demand. Let us represent them through the equation for easier understanding:
- When Supply > Demand, the price falls.
- When Demand > Supply, the price rises
- When Demand = Supply, there is no major price change observed (This is what causes the price to consolidate in a specific area and is also due to the period of low volatility)
Second is The Law of Cause and Effect:
When we refer to Demand and Supply, this is not a one-off period where if the Supply is greater than the Demand, the price falls. In order for the Supply to be greater than the Demand, the market will observe stages/periods. Wyckoff calls these periods Accumulation and Distribution.
Therefore, a period of Accumulation and a period of Distribution are the Cause that leads to an Effect which is an uptrend followed after Accumulation and downtrend followed after Distribution.
In order to give you a basic visual representation for better understanding, you may see the following:
Period of Wyckoff Distribution:
Third is the Law of Effort against Result:
When Wyckoff says ‘Effort’ he relates it with the trading volume. When there is a significant sell-off (downtrend) and the volume is high, you can infer that there is a huge sell volume and the downtrend may continue. Therefore, the Effort (Volume) is in harmony with the price (Result). However, if you see high volume but the price is consolidating and starts to form a trading range, you can infer that now the Effort (Volume) is not in harmony with the price anymore i.e., the volume and price are diverging (Result) which indicates that the downtrend may halt and the price may reverse for an uptrend.
*Trading volume indicates the intensity/number of quantities traded over a given period. In other words, the volume of exchange of currencies or shares.
In order to give you a basic visual representation for better understanding, you may see the following:
For instance, the EURUSD market starts to consolidate in a trading range with a very high volume after a significant downtrend/bearish trend. The high volume, on one hand would indicate Effort but the sideways movement that indicates low volatility, in contrast, is not in harmony with the Effort (High volume). This could indicate that the downtrend may potentially be over, and a reversal is imminent.
The Composite Man
Now let us shed light on The Composite Man:
Look at the Composite man as someone imaginary in the market who is the single market participant running the market. This is to serve the purpose of easily following the trends in the market. The Composite Man represents the biggest market players or the market makers who are usually institutional investors. The composite man ensures to buy the exact lows and sell the exact highs which are 90% (or even more) of the time opposed to retail traders’ positions.
The idea here is to follow the Composite Man and predict his strategy and follow that method. As we all have heard the saying; “If you cannot beat them, join them”.
The market cycle which the Composite Man follows includes the following 4 phases:
- Accumulation
- Uptrend
- Distribution
- Downtrend
Let us again give you a basic visual representation of the market cycle for a better understanding:
What is happening in the Market Cycle above?
In the Accumulation phase, the Composite Man is buying/holding the asset at different prices gradually to not have a significant price change. Very often this phase is observed in a consolidation period (fixed trading range). After it starts surging the market is indicated by the Uptrend phase. In contrast to this, the Composite man does the opposite in the Distribution phase i.e., he starts to sell the asset at different levels in a consolidation phase to eventually drop the market for a downtrend.
These Phases may have additional cycles in between known as re-accumulation for a further surge and re-distribution for a further drop in the market.
Wyckoff Schematics
Now let us move on to Wyckoff Schematics:
Wyckoff Schematics are the most popular area of Wyckoff theory. Here, Wyckoff divides the Accumulation and Distribution phases into multiple phases and events. Let us first dive into Accumulation Schematic. We will mark down the Phases and the Events to be observed in each phase. Following is the Accumulation Schematic observed in EURUSD in a 30-minute time-frame.
*Schematics can be observed in all time-frames
Accumulation Schematic:
Phase A:
In this Phase, let us cover step by step the events sequentially. The first sign that the downtrend is about to slow down or halt is through Preliminary Support (PS).
Preliminary Support (PS) – shows the buyers’ interest to gain control but it is not strong enough to prevent the market from falling down further. The weak control of buyers leads to the next event called the Selling Climax (SC).
Selling Climax (SC)- is the place where if you think in terms of the Composite Man, the panic sell-off from retail traders is absorbed by Institutional investors.
Automatic Rally (AR) – The panic sell-off which is absorbed by the Institutional buyers leads to a sudden surge labeled as the AR. This High is used to identify the resistance lines of the Schematic. Secondary Test (ST) – as the name suggests occurs when the price falls near or below the SC. This is the point of indecisiveness to see whether the downtrend is over. You will also observe lower trading volume in this region. This Secondary test is usually followed by another secondary test in Phase B.
Phase B:
Let us quickly recall the Cause-and-Effect law we discussed earlier. This is where with significant volume (Cause), the price does not fall further and starts consolidating (Effect). Here is where the Composite Man holds accumulates most of the holdings all the while testing the resistance and support lines identified through AR and SC/ST. In this Phase, you can observe multiple Secondary Tests.
Phase C:
If you notice, in this phase, the only main event you will observe is called the Spring, also termed as the shakeout. This is where the Composite man is ensuring that the last sellers are absorbed by him. In other words, you can also term it a Bear trap.
The Spring low is more often observed below the support lines which also leads to retail positions stopping out before a surge. It is also extremely important not to look for the identical setup each time. The schematics may vary from this and it would still be a valid schematic. As long as you understand the mechanism behind the schematics, you will be able to identify the schematic even if they are not identical to the one shown above.
Phase D:
This Phase will observe a significant increase in trading volume as well as the volatility. The market now is switching momentum for a run upward. In other words, the cause is now soon going to have its effect. As you can see, the events in this phase include Test and Last point of Supply (LPS). You can observe multiple tests in this region which are observed by higher lows (structures) for a run upwards.
Last point of Supply (LPS) – indicates that it is the last low from where the price is going to form higher highs. This forms the series of supports with higher lows.The LPS is followed by the Signs of Strength.
Signs of Strength (SOS) – This is the event where the previous resistance lines marked by AR are broken and the price is now showing the momentum for an uptrend. However, this will be followed by one Last point of supply or Back-Up (BU) which will more often than not retest the resistance line broken which is now acting as the support. This would ideally be the last event in Phase D.
Phase E:
Phase E is the final stage where the Accumulation schematic is now complete and the consolidated trading range is now broken. This is a confirmation that we are now headed for an uptrend.
Wyckoff Distribution Schematic:
Now in order to understand the Wyckoff Distribution Schematic, looking at it in contrast to Accumulation Schematic will make it easier for understanding. Let us now learn what information Distribution Schematic provides about the market. Following is the Distribution Schematic observed in EURUSD on 1-hour time-frame.
Phase A:
In this Phase, let us cover step by step the events sequentially. First sign that the uptrend is about to slow down or halt is through Preliminary Supply (PSY).
Preliminary Supply (PSY) – shows the sellers interest to gain control but it is not strong enough to prevent the market from surging further. The weak control of sellers leads to the next event called the Buying Climax (BC).
Buying Climax (BC) – isthe place where if you think in terms of the Composite Man, the panic buying from retail traders is absorbed by Institutional investors.
Automatic Reaction (AR) -The panic buying which is absorbed by the Institutional buyers leads to a sudden fall labeled as the AR. This Low is used to identify the support lines of the Schematic.
Secondary Test (ST) – occurs when the price falls near or below the BC. This is the point of indecisiveness to see whether the uptrend is over. You will also observe lower trading volume in this region. This Secondary test is usually followed by another secondary test in Phase B
Phase B:
Again, Cause-and-Effect law is in play in this Phase. This is where with significant volume (Cause), the price does not rise further and starts consolidating (Effect). Here is where the Composite Man sells most of the holdings all the while testing the resistance and support lines identified through AR and BC/ST. In this Phase, you can observe multiple Secondary Tests.
Sign of weakness (SOW) – is observed in Phase B with a slight drop below the Automatic reaction (AR) which indicates the dominance of supply.
Up-thrust (UT) – At times, the market will move above the resistance level created by the Buying Climax (BC) which is labeled as the Up-thrust (UT).
Phase C:
In this phase, the main event you will observe is called the UTAD. This is where the Composite man is ensuring that the last buyers are absorbed by him. In other words, you can also term it as a Bull trap.
The UTAD high is more often observed above the resistance lines which also leads to retail positions stopping out before a final drop. This is the opposite of Spring in Accumulation Schematic.
Phase D:
Again, just like in Accumulation Schematic, this Phase will observe a significant increase in trading volume as well as the volatility. The market now is switching momentum for a run downwards. As you can see, the events in this phase include Last point of Supply (LPS). You can observe multiple tests in this region which are observed by lower highs (structures) for a run downwards.
This leads to a very clear sign of weakness (SOW) and is eventually dropped below the support lines.
Phase E:
Phase E is the final stage where the Distribution schematic is now complete and the consolidated trading range is now broken. This is a confirmation that we are now headed for a downtrend.
Five-step approach to the Market
Now let us move on to Wyckoff’s five-step approach to the Market:
The five-step approach brings everything in order to correctly follow the steps for its most effective implementation.
Step 1: Determine the trend.
Step 2: Determine the strength/momentum (through volume)
Step 3: Identify pairs that show sufficient cause in the schematics for an entry.
Step 4: Determine how likely is the move. (This is by identifying the schematic in line with the bigger trend alongside eyeing what information price and volume provide)
Step 5: Time your entry.
Conclusion
Mastering the Wyckoff Method can be a game-changer for traders looking to improve their market analysis and trading strategies. By understanding the principles, phases, and practical applications of Wyckoff method, you can unlock the secrets of market trends and achieve trading success. So why wait? Start implementing the Wyckoff Distribution Method today and watch your trading performance soar.
