The Wyckoff Method – Part II

Almost a century has passed since its inception, but the Wyckoff Method is still widely used today. It is undoubtedly much more than a TA indicator, as it encompasses many principles, theories and trading techniques.

Essentially, the Wyckoff Method enables investors to make more logical decisions rather than trading out of emotion. Wyckoff’s extensive work provides traders and investors with several tools to reduce risk and increase their chances of success. Still, there is no 100% foolproof technique when it comes to investing. One should always be mindful of the risks, especially in the highly volatile cryptocurrency markets.

The Composite Man

Wyckoff created the Composite Man (or Composite Operator) idea as the imaginary identity of the market. He suggested that investors and traders should study the stock market as if a single company controlled it. This would make it easier for them to follow market trends.

In essence, the Composite Man represents the biggest players (so-called market makers), such as high net worth individuals and institutional investors. It always acts in its interest to ensure that it can buy cheap and sell dear.

The composite man’s behaviour is the opposite of most private investors, among whom Wyckoff observed frequent money losses. However, according to Wyckoff, the Composite Man uses a somewhat predictable strategy that investors can learn from.

Let’s use the Composite Man idea to illustrate a simplified market cycle. Such a market cycle consists of four main phases: Accumulation, Uptrend, Distribution and Downtrend.

Accumulation

The Composite Man accumulates assets ahead of most investors. A sideways movement usually characterises this phase. Accumulation is gradual to prevent the price from changing significantly.

Upward trend

When the Composite Man holds enough shares and the selling power is exhausted, he begins to drive the market upwards. Naturally, the emerging trend attracts more investors, which increases demand.

Notably, there can be several accumulation phases during an uptrend. We can call them re-accumulation phases, where the larger trend stops for a while and consolidates before continuing its upward movement.

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As the market rises, other investors are encouraged to buy. Eventually, even the general public gets excited enough to get involved. At this point, when so-called FOMO hits the market, demand is excessively higher than supply.

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Distribution

Next, the Composite Man begins to distribute his holdings. He sells his profitable positions at a late stage to those who come into the market. Typically, the distribution phase is characterised by a sideways movement, absorbing demand until it is exhausted.

Downward trend

Soon after the distribution phase, the market returns to the downside. In other words, after the Composite Man has sold a great portion of his shares, he begins to push the market down. Eventually, supply becomes much greater than demand, and the downtrend is established.

Similar to the uptrend, the downtrend can also have redistribution phases. This is a short-term consolidation between large price drops. This may include dead cat bounces or the so-called bull traps where some buyers are caught hoping for a trend reversal that does not occur – yet. When the bearish trend is finally completed, a new accumulation phase begins.

Wyckoff’s schematics

The accumulation and distribution schematics are probably the most popular part of Wyckoff’s work – at least within the cryptocurrency community. These models divide the accumulation and distribution phases into further, smaller sections. The sections are split into five phases (A to E) and several Wyckoff events, which are briefly described as follows.

Phase A

Selling power decreases, and the downward trend begins to slow down. An increase in trading volume usually characterises this phase. Preliminary Support (PS) indicates that a few buyers are emerging, but still not enough to stop the downward movement.

The Selling Climax (SC) is formed by intense selling activity when investors capitulate. This is often a point of high market volatility where panic selling creates large candlesticks and wicks. The sharp decline quickly leads to recovery or automatic rally (AR) as buyers absorb the excess supply. The trading range (TR) of an accumulation scheme is defined by the distance between the SC low and the AR high.

As the name already suggests, the Secondary Test (ST) takes place when the market falls near the SC region and is tested to see if the downtrend is really over or not. At this point, trading volume and volatility tend to be lower. While the Secondary Test often forms a higher low relative to the SC, this may not always be the case.

Phase B

Based on Wyckoff’s formulated law of cause and effect, Phase B can be seen as the cause leading to an effect.

Essentially, Phase B is the consolidation phase in which the Composite Man accumulates the highest number of assets. During this phase, the market tends to test both the resistance and support levels of the trading range.

During Phase B, there may be numerous secondary tests (STs). In some cases, they may even produce higher highs (bull traps) and lower lows (bear traps) concerning SC and AR of Phase A.

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Phase C

A typical accumulation phase C contains a so-called spring. It often acts as a final bear trap before the market reaches higher lows. During Phase C, the Composite Man makes sure that there is little supply left in the market, i.e. those that should already be sold.

Spring often breaks support levels to stop traders and mislead investors. We can describe it as a last attempt to buy stocks at a lower price before the uptrend begins. The bear trap causes retail investors to abandon their holdings.

In some cases, however, support levels hold, and the spring does not occur. In other words, there may be accumulation schemes that represent all other elements except the spring. However, the overall scheme remains valid.

Phase D

Phase D represents the time transition between cause and effect. It lies between the accumulation zone (Phase C) and the trading range breakout (Phase E).

Typically, Phase D portraits a significant increase in trading volume and higher volatility. It typically has a Last Point Support (LPS) that reaches a higher low before the market moves up. The LPS often precedes a firm breakout of resistance levels, which in turn then creates higher highs. This defines Signs of Strength (SOS) as previous resistance levels become brand new supports.

Despite the somewhat confusing terminology, more than one LPS can occur in Phase D. They have often increased trading volume while testing the new support levels. In some cases, the price may define a temporary consolidation zone before effectively breaking through the larger trading range and moving into Phase E.

Phase E

Phase E is the final stage of an accumulation pattern. It is characterised by an apparent breakout of the trading range caused by increased market demand. This is the point at which the trading range is effectively broken, and a new uptrend begins.

Distribution scheme

Essentially, the distribution scheme works oppositely to accumulation but with slightly different terminology.

Phase A

The first phase occurs when an established upward trend begins to slow due to falling demand. Preliminary supply (PSY) indicates that selling power is showing, although it is still not strong enough to stop the upward movement. The buying climax (BC) is then formed by intense buying activity. This is usually caused by inexperienced traders buying out of emotion.

Next, the sharp rise causes an Automatic Reaction (AR) as the market makers absorb the excessive demand. In other words, the Composite Man begins to distribute his holdings to the deceased buyers. The Secondary Test (ST) occurs when the market revisits the BC region and frequently forms a lower high.

Phase B

Phase B of a distribution acts as a consolidation zone (cause) that precedes a downtrend (effect). During this phase, the composite man sells off his assets gradually, absorbing and weakening market demand.

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Usually, the upper and lower bands of a trading range are tested several times, including short-term bear and bull traps. Sometimes the market moves above the resistance level created by the BC, resulting in an ST, which can also be called an Upthrust (UT).

Phase C

In some cases, the market will make a final bull trap after the consolidation phase. It is called UTAD or Upthrust After Distribution. It is the opposite of an accumulation spring.

Phase D

Phase D of distribution is pretty much a mirror image of accumulation. It usually has a Last Point of Supply (LPSY) right in the middle of the relevant range, creating a lower high. From there, new LPSYs is created – either around or just below the support zone. An obvious sign of weakness (SOW) occurs when the market falls below the support lines.

Phase E

The last phase of a distribution marks the beginning of a downtrend with a noticeable break below the previous trading range caused by a strong dominance of supply over demand.

Wyckoff’s five-step approach

Wyckoff further developed a five-step approach to the market based on his many principles and techniques. In short, this approach can be seen as a way to put his teachings into practice.

Step 1: Determine the trend

What is the current trend, and where is it likely to go? What is the relationship between supply and demand?

Step 2: Determine the strength of the asset

How strong is the asset relative to the market? Are they moving in similar or opposite ways?

Step 3: Look for those assets with sufficient cause

Is there sufficient cause to take a position? Is the cause strong enough for the potential rewards (effects) to be worth the risks?

Step 4: Determine how likely the move is

Is the asset ready to move? What is its position within the larger trend? What do price and volume suggest? This step often involves using Wyckoff’s buy and sell tests.

Step 5: Time your entry

The final step is all about timing. Usually, a stock is analysed against the general market. 

For example, a trader may compare the price movement of a stock in relation to the Dow Jones Industrial index. Depending on the position within their individual Wyckoff scheme, such an analysis can provide insights into the subsequent movements of the asset. This ultimately facilitates the establishment of a good entry point.

In particular, this method works better for assets that move in tandem with the general market or index. However, in cryptocurrency markets, this correlation is not always present.

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