For many investors, the “Wyckoff method” or Wyckoff cycle is the basis of technical analysis. Many elements of this method are also used by technical analysis enthusiasts without them realizing it.
This article provides an overview of Wyckoff’s approach and guidelines for identifying investments or conducting an analysis of the accumulation and distribution phases of the market. Although the Wyckoff method was originally designed for equities, it can be applied to any market where large institutional investors are present. Think of the commodities market, the bond market or the currency market.
Who was Richard D. Wyckoff?
Richard Demille Wyckoff (1873-1934) was a pioneer in the technical approach to the study of the stock market in the early 20th century. He is considered one of the five “titans” of technical analysis along with Dow, Gann, Elliott and Merrill. At 15, he was working for a broker in New York. Ten years later, at the age of 25, he owned his own company. He was the founder of the famous The Magazine of Wall Street, for which he was editor for some 20 years.
In its heyday, the magazine had over 200,000 subscribers. Wyckoff was a keen student of the markets. He was an active investor and a fan of technical analysis. He observed the market activities of legendary investors of his time, including J.P. Morgan and Jesse Livermore. The Wyckoff Method was inspired by his observations and dealings with these and other great investors. It consists of a series of laws, principles and techniques of investment methodology, financial management and mental discipline.
Wyckoff noticed that many beginning investors were regularly misled. In the 1930s, he opened a school that would later become the Stock Market Institute. At the time, the school offered a course on the concepts Wyckoff learned about identifying the accumulation and distribution of large institutional parties that allows one to take positions as those large parties do.
Wyckoff’s 5-step approach
The Wyckoff method includes a 5-step approach (Wyckhoff cycles) to stock selection and can be summarized as follows
1) Determine the current trend and probable future trend
An important step in this approach is to study the market and determine whether a stock is in a consolidation phase or in a trend. With this judgment, you can decide whether to go long or short.
2) Selecting stocks in line with the trend
You should select stocks that are stronger than the market in an uptrend. And vice versa in the case of a downtrend where you should select stocks that are weaker than the market.
3) Selecting stocks in an accumulation or distribution phase
A crucial element of Wyckoff’s stock selection was the unique method he used to identify price targets using charts. If you are considering taking long positions, then opt for stocks in the accumulation or re-accumulation phase and with sufficient cause to reach your target.
4) Determine the probability of the stock’s movement
Take for example a consolidation phase after a long rally. According to the Wyckoff method, a short position could be justified in this case.
5) Determine the timing of your investments using a stock index
The movement of more than ¾ of individual stocks correlates with the overall market. Therefore, measuring the strength of the overall market using stock indices increases your chances of successful trading. The specific principles of the Wyckoff method can help you anticipate potential market changes in the indices.
The Wyckoff Price Cycle
According to Wyckoff, it is possible to explain and anticipate the market through a detailed analysis of demand and supply by studying price movement, volume and timing. As a trader, he observed the activities of other successful traders and groups that dominated certain stocks. Using Point and Figure (P&F) charts, he was able to decipher the future intentions of these large investors.
Wyckoff conceptualized a pattern of how large investors prepare for and implement bull and bear markets. Long positions are executed at the end of the downtrend or at the end of the accumulation phase, while short positions are initiated at the end of the uptrend or at the end of the distribution phase. The Wyckoff cycle is illustrated below.
Wyckoff’s Three Laws
Wyckoff’s methodology is based on three fundamental laws that influence many aspects of analysis. These laws are used to determine the current and future direction of the market or of individual stocks and to select the best stocks to take long or short positions.
The Law of Supply and Demand
The first law states that prices rise when demand exceeds supply and fall when supply exceeds demand. This is one of the most fundamental principles of the Wyckoff method. The investor can study the balance between supply and demand by comparing price measures and volume bars. This law may be simple, but learning to understand the implications of the supply and demand figures takes a lot of practice.
The Law of Cause and Effect
The second law states that the differences between demand and supply are not random. According to Wyckoff, they come after periods of preparation for specific events. In the terms of the Wyckoff method, a period of accumulation (cause) eventually leads to an upward trend (consequence). In contrast, a period of distribution (cause) leads to a decline (effect).
Wyckoff created methods for defining trading targets based on accumulation and distribution periods. He was able to estimate the likely trend after the break of an accumulation or distribution zone.
The effort versus result law
Divergences between volume and price often indicate that a change in trend direction is coming in the near future. If the price rises with high volume (high effort) but low earnings (low result) then this could suggest that large investors are selling their shares and anticipating a trend reversal.
Wyckoff Patterns
One of the goals of the Wyckoff method is to improve market timing. Take, for example, an investor who wants to take a position when he or she expects a future move that has a favorable risk/reward ratio. Consolidation zones are areas where the uptrend stops rising and the downtrend stops falling and there is a relative balance between demand and supply. Market makers such as large institutional and other large professional investors prepare for their next bull or bear campaign by accumulating shares (or distributing shares) in the consolidation zone.
In both accumulation and distribution zones, large investors are actively buying and selling. The difference is that in an accumulation zone, the volume of shares bought is greater than the volume of shares sold, as opposed to a distribution zone where the volume of shares sold is greater than the volume of shares bought. The accumulation or distribution rate determines the next move out of the zone.
A successful analyst adept at the “Wyckoff method” should therefore be able to correctly assess the direction and magnitude of the new trend out of a consolidation or allocation zone. Wyckoff has developed guidelines for identifying the phases and events that occur within a zone, which in turn form the basis for determining trading targets within the emerging trend. These concepts are illustrated in the following two diagrams (accumulation and distribution).
Accumulation
Phase A
This phase marks the end of the downward trend. Up to now, supply has dominated. The Preliminary Support (PS) and the Sales High (SC) indicate a decline in supply. Generally, these events can be seen very clearly on the charts. Large price movements and high volume indicate a transfer of a significant number of shares from the general public to the large institutional and professional parties. This intense selling force is followed by an Automatic Rally (AR), where the excess supply is absorbed by buyers and investors close their short positions.
A secondary test (ST) then occurs in or around the Selling climax (SC) area. Trading volume tends to be lower. Typically, the ST is at or just above the SC level. The lows of the SC and ST and the level of the AR determine the limits of the accumulation zone. Support and resistance lines can then be drawn to highlight the first high and low.
Sometimes the downtrend ends without significant volume activity. In general, it is best to look at the PS, SC, AR and ST points as they not only give a more accurate picture but also clearly indicate that large investors have definitely moved into accumulation mode.
Phase B
The function of the B phase can be referred to as the phase of building a case for a new uptrend. Remember, this is Wyckoff’s second law of Cause and Effect. In the B phase, large investors accumulate relatively cheap stocks in anticipation of the next price increase. The process of institutional accumulation can last a long time (sometimes a year or more). Stocks are bought at lower prices and price fluctuations are controlled by taking short positions. Several Secondary Tests (ST in Phase B) occur as well as bullish breaks on the upper side of the accumulation zone.
Large investors buy stocks as the accumulation progresses, their goal being to absorb as much of the remaining supply as possible. Institutional buying and selling generates the upward and downward movements that characterize this zone. At the beginning of the zone, price fluctuations are already significant and accompanied by high volume. As more professional investors absorb supply, the volume in the accumulation zone decreases. Once the supply is exhausted, the stock is ready to move into phase C.
Phase C
This is the phase where the price undergoes a litmus test of the remaining supply, allowing institutional investors to see if the stock is ready to start a new uptrend. This phase contains a Spring. This is a price move below the support level of the accumulation zone (established during Phase A and Phase B) that quickly reverses within the zone.
This is an example of a “bear trap” as the drop below the support area here appears to signal a resumption of the downtrend. In reality, this marks the beginning of a new uptrend. Small investors are often misled and abandon their positions. If the Spring volume is low (or the test volume), then this means that the stock is probably ready to start a new uptrend.
Phase D
If the analysis has been done correctly, then a development of demand that gradually exceeds supply should become clear. Phase D has SOS (Signs of Strength). That is, a significant increase in volume and LPS (Last Support Points). The previous resistance levels become the new support levels. In Phase D, LPS are excellent entry points to initiate lucrative long positions.
Phase E
In phase E, the stock leaves the accumulation zone. Buyers have regained full control and the new uptrend is clearly underway. Reactions are often short-lived and new consolidation zones are formed at ever higher levels. What is referred to as “re-accumulation” can occur at any time in the E phase. These consolidation zones are sometimes called dips, indicating that the stock is heading for higher prices.
The distribution
Phase A
This phase marks the end of the upward trend. Until now, demand has been dominant. The Preliminary supply (PSY) and a Bying climax (BC) suggest an increase in supply, or the beginning of the selling force. These events can be seen very clearly on the charts. They are most often followed by an Automatic reaction (AR) and a Secondary test (ST) of the BC with reduced volume. An end of the uptrend without much action is also possible. In this case, there will be an exhaustion of demand with decreasing volume. Each new upward movement loses momentum and considerable supply should appear.
Phase B
The B phase serves to build up a cause and prepare for a new downtrend. Market makers gradually sell off their stocks and initiate short positions in anticipation of the next downtrend. The characteristics of the B phase are comparable to those of the accumulation B phase. Except that here, the big investors are the sellers of securities aiming to exhaust the remaining demand. The balance between demand and supply seems to have shifted to the supply side, not the demand side. The movement from ST to SOW (Sign of Weakness) is most often accompanied by significantly higher volume.
Phase C
The C phase of distribution in the Wyckoff method can be manifested by an ‘Upthrust after Distribution’ (UTAD). This is the opposite of an Accumulation Spring and corresponds to a price movement above the distribution resistance that quickly returns to the area. In most cases, this is a test of the remaining demand. This is also a “bull trap” because it appears to indicate a resumption of the uptrend, but in reality it is used to mislead uninformed or low-information investors.
A UTAD allows large investors to mislead the public as to the future direction of the trend. This, in turn, allows them to sell other stocks at higher prices to uninformed or low-information investors before the downtrend begins. In addition, a UTAD can induce small investors positioned short to cover their shares and transfer them to the large investors who are at the origin of the movement. This is called “stophunting”.
Demand in the distribution area may be so low that the price fails to reach the level of the initial CB or ST. In this case, the Phase C demand test is represented by a UTAD with a lower peak in the distribution area.
Phase D
Phase D begins when the UTAD test in Phase C displays a false upward trend recovery. During the D phase, the price falls toward the distribution support area. A clear break of support or a drop below half of the distribution zone after a UTAD shows that supply is now dominating. This D phase is characterized by several timid reactions. These LPSYs are good opportunities to initiate profitable short positions or add to your existing short positions. Traders who have not yet sold off their shares during the D phase may well find themselves in a difficult situation.
Phase E
Phase E is the last stage of a distribution and marks the beginning of a downtrend. The stock leaves the distribution zone and the sellers are in control. As soon as the distribution support area is broken by a large SOW, this break is tested by a small upward price movement that fails near or at the support area. This is an opportunity to go short and sell the stock. Subsequent upward price movements in this downtrend will very often be quite small. After a considerable downward movement, a climax may well indicate the beginning of a re-distribution or accumulation.
The Wyckoff method in practice
The trader who analyzes the market using the “Wyckoff method” must be careful. The phases and characteristics of the accumulation zone and distribution zone or the patterns of these zones are models that are not always applicable to the reality of the market. Therefore, having sufficient knowledge about how supply and demand can influence the market is crucial. The Wyckoff method example below illustrates a distribution phase. While there are similarities to the Wyckoff distribution pattern, there are some differences that could be problematic for the novice investor. Keep in mind that the market does not follow these patterns precisely.