What is the Wyckoff Method?
The Wyckoff Method was developed by Richard Wyckoff in the early 1930s. It consists of a series of principles and strategies initially designed for traders and investors. Wyckoff dedicated a significant part of his life teaching, and his work impacts much of modern technical analysis (TA). While the Wyckoff Method was originally focused on stocks, it is now applied to all sorts of financial markets.
A lot of Wyckoff’s work was inspired by the trading methods of other successful traders (especially Jesse L. Livermore). Today, Wyckoff is held in the same high regard as other key figures, such as Charles H. Dow, and Ralph N. Elliott.
Wyckoff did extensive research, which led to the creation of several theories and trading techniques. This article gives an overview of his work. The discussion includes:
Three fundamental laws;
The Composite Man concept;
A methodology for analyzing charts (Wyckoff’s Schematics);
A five-step approach to the market.
Wyckoff also developed specific Buying and Selling Tests, as well as a unique charting method based on Point and Figure (P&F) charts. While the tests help traders spot better entries, the P&F method is used to define trading targets. However, this article won’t dive into these two topics.
The three laws of Wyckoff
The Law of Supply and Demand
The first law states that prices rise when demand is greater than supply, and drop when the opposite is true. This is one of the most basic principles of financial markets and is certainly not exclusive to Wyckoff’s work. We may represent the first law with three simple equations:
Demand > Supply = Price rises
Demand < Supply = Price drops
Demand = Supply = No significant price change (low volatility)
In other words, the first Wyckoff law suggests that an excess of demand over supply causes prices to go up because there are more people buying than selling. But, in a situation where there is more selling than buying, the supply exceeds demand, causing the price to drop.
Many investors who follow the Wyckoff Method compare price action and volume bars as a way to better visualize the relation between supply and demand. This often provides insights into the next market movements.
The Law of Cause and Effect
The second law states that the differences between supply and demand are not random. Instead, they come after periods of preparation, as a result of specific events. In Wyckoff's terms, a period of accumulation (cause) eventually leads to an uptrend (effect). In contrast, a period of distribution (cause) eventually results in a downtrend (effect).
Wyckoff applied a unique charting technique to estimate the potential effects of a cause. In other terms, he created methods of defining trading targets based on the periods of accumulation and distribution. This allowed him to estimate the probable extension of a market trend after breaking out of a consolidation zone or trading range (TR).
The Law of Effort vs. Result
The third Wyckoff law states that the changes in an asset’s price are a result of an effort, which is represented by the trading volume. If the price action is in harmony with the volume, there is a good chance the trend will continue. But, if the volume and price diverge significantly, the market trend is likely to stop or change direction.
For instance, imagine that the Bitcoin market starts to consolidate with a very high volume after a long bearish trend. The high volume indicates a big effort, but the sideways movement (low volatility) suggests a small result. So, there is a lot of Bitcoins changing hands, but no more significant price drops. Such a situation could indicate that the downtrend may be over, and a reversal is near.
The Composite Man
Wyckoff created the idea of the Composite Man (or Composite Operator) as an imaginary identity of the market. He proposed that investors and traders should study the stock market as if a single entity was controlling it. This would make it easier for them to go along the market trends.
In essence, the Composite Man represents the biggest players (market makers), such as wealthy individuals and institutional investors. It always acts in his own best interest to ensure he can buy low and sell high.
The Composite Man’s behavior is the opposite of the majority of retail investors, which Wyckoff often observed losing money. But according to Wyckoff, the Composite Man uses a somewhat predictable strategy, from which investors can learn from.
Let’s use the Composite Man concept to illustrate a simplified market cycle. Such a cycle consists of four main phases: accumulation, uptrend, distribution, and downtrend.
The Composite Man accumulates assets before most investors. This phase is usually marked by a sideways movement. The accumulation is done gradually to avoid the price from changing significantly.
When the Composite Man is holding enough shares, and the selling force is depleted, he starts pushing the market up. Naturally, the emerging trend attracts more investors, causing demand to increase.
Notably, there may be multiple phases of accumulation during an uptrend. We may call them re-accumulation phases, where the bigger trend stops and consolidates for a while, before continuing its upward movement.
As the market moves up, other investors are encouraged to buy. Eventually, even the general public become excited enough to get involved. At this point, demand is excessively higher than supply.
Next, the Composite Man starts distributing his holdings. He sells his profitable positions to those entering the market at a late stage. Typically, the distribution phase is marked by a sideways movement that absorbs demand until it gets exhausted.
Soon after the distribution phase, the market starts reverting to the downside. In other words, after the Composite Man is done selling a good amount of his shares, he starts pushing the market down. Eventually, the supply becomes much greater than demand, and the downtrend is established.
Similar to the uptrend, the downtrend may also have re-distribution phases. These are basically short-term consolidation between big price drops. They may also include Dead Cat Bounces or the so-called bull traps, where some buyers get trapped, hoping for a trend reversal that doesn’t happen. When the bearish trend is finally over, a new accumulation phase begins.