Wyckoff Schematic Explained
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.
The Accumulation and Distribution Schematics are likely the most popular part of Wyckoff’s work — at least within the cryptocurrency community. These models break down the Accumulation and Distribution phases into smaller sections. The sections are divided into five Phases (A to E), along with multiple Wyckoff Events, which are briefly described below.
The selling force decreases, and the downtrend starts to slow down. This phase is usually marked by an increase in trading volume. The Preliminary Support (PS) indicates that some buyers are showing up, but still not enough to stop the downward move.
The Selling Climax (SC) is formed by an intense selling activity as investors capitulate. This is often a point of high volatility, where panic selling creates big candlesticks and wicks. The strong drop quickly reverts into a bounce or Automatic Rally (AR), as the excessive supply is absorbed by the buyers. In general, the trading range (TR) of an Accumulation Schematic is defined by the space between the SC low and the AR high.
As the name suggests, the Secondary Test (ST) happens when the market drops near the SC region, testing whether the downtrend is really over or not. At this point, the trading volume and market volatility tend to be lower. While the ST often forms a higher low in relation to the SC, that may not always be the case.
Based on Wyckoff’s Law of Cause and Effect, Phase B may be seen as the Cause that leads to an Effect.
Essentially, Phase B is the consolidation stage, in which the Composite Man accumulates the highest number of assets. During this stage, the market tends to test both resistance and support levels of the trading range.
There may be numerous Secondary Tests (ST) during Phase B. In some cases, they may produce higher highs (bull traps) and lower lows (bear traps) in relation to the SC and AR of the Phase A.
A typical Accumulation Phase C contains what is called a Spring. It often acts as the last bear trap before the market starts making higher lows. During Phase C, the Composite Man ensures that there is little supply left in the market, i.e., the ones that were to sell already did.
The Spring often breaks the support levels to stop out traders and mislead investors. We may describe it as a final attempt to buy shares at a lower price before the uptrend starts. The bear trap induces retail investors to give up their holdings.
In some cases, however, the support levels manage to hold, and the Spring simply does not occur. In other words, there may be Accumulation Schematics that present all other elements but not the Spring. Still, the overall scheme continues to be valid.
The Phase D represents the transition between the Cause and Effect. It stands between the Accumulation zone (Phase C) and the breakout of the trading range (Phase E).
Typically, the Phase D shows a significant increase in trading volume and volatility. It usually has a Last Point Support (LPS), making a higher low before the market moves higher. The LPS often precedes a breakout of the resistance levels, which in turn creates higher highs. This indicates Signs of Strength (SOS), as previous resistances become brand new supports.
Despite the somewhat confusing terminology, there may be more than one LPS during Phase D. They often have increased trading volume while testing the new support lines. In some cases, the price may create a small consolidation zone before effectively breaking the bigger trading range and moving to Phase E.
The Phase E is the last stage of an Accumulation Schematic. It is marked by an evident breakout of the trading range, caused by increased market demand. This is when the trading range is effectively broken, and the uptrend starts.
In essence, the Distribution Schematics works in the opposite way of the Accumulation, but with slightly different terminology.
The first phase occurs when an established uptrend starts to slow down due to decreasing demand. The Preliminary Supply (PSY) suggests that the selling force is showing up, although still not strong enough to stop the upward movement. The Buying Climax (BC) is then formed by an intense buying activity. This is usually caused by inexperienced traders that buy out of emotions.
Next, the strong move up causes an Automatic Reaction (AR), as the excessive demand is absorbed by the market makers. In other words, the Composite Man starts distributing his holdings to the late buyers. The Secondary Test (ST) occurs when the market revisits the BC region, often forming a lower high.
The Phase B of a Distribution acts as the consolidation zone (Cause) that precedes a downtrend (Effect). During this phase, the Composite Man gradually sells his assets, absorbing and weakening market demand.
Usually, the upper and lower bands of the trading range are tested multiple times, which may include short-term bear and bull traps. Sometimes, the market will move above the resistance level created by the BC, resulting in an ST that can also be called an Upthrust (UT).
In some cases, the market will present one last bull trap after the consolidation period. It’s called UTAD or Upthrust After Distribution. It is, basically, the opposite of an Accumulation Spring.
The Phase D of a Distribution is pretty much a mirror image of the Accumulation one. It usually has a Last Point of Supply (LPSY) in the middle of the range, creating a lower high. From this point, new LPSYs are created — either around or below the support zone. An evident Sign of Weakness (SOW) appears when the market breaks below the support lines.
The last stage of a Distribution marks the beginning of a downtrend, with an evident break below the trading range, caused by a strong dominance of supply over demand.
Does the Wyckoff Method work?
Naturally, the market doesn’t always follow these models accurately. In practice, the Accumulation and Distribution Schematics can occur in varying ways. For example, some situations may have a Phase B lasting much longer than expected. Or else, the Spring and UTAD Tests may be totally absent.
Still, Wyckoff’s work offers a wide range of reliable techniques, which are based on his many theories and principles. His work is certainly valuable to thousands of investors, traders, and analysts worldwide. For instance, the Accumulation and Distribution schematics may come handy when trying to understand the common cycles of financial markets.
Wyckoff’s five-step approach
Wyckoff also developed a five-step approach to the market, which was based on his many principles and techniques. In short, this approach may be seen as a way to put his teaching into practice.
Step 1: Determine the trend.
What is the current trend and where it is likely to go? How is the relation between supply and demand?
Step 2: Determine the asset’s strength.
How strong is the asset in relation to the market? Are they moving in a similar or opposite fashion?
Step 3: Look for assets with sufficient Cause.
Are there enough reasons to enter a position? Is the Cause strong enough that makes the potential rewards (Effect) worth the risks?
Step 4: Determine how likely is the move.
Is the asset ready to move? What is its position within the bigger trend? What do the price and volume suggest? This step often involves the use of Wyckoff’s Buying and Selling Tests.
Step 5: Time your entry.
The last step is all about timing. It usually involves analyzing a stock in comparison to the general market.
For example, a trader can compare the price action of a stock in relation to the S&P 500 index. Depending on their position within their individual Wyckoff Schematic, such an analysis may provide insights into the next movements of the asset. Eventually, this facilitates the establishment of a good entry.
Notably, this method works better with assets that move together with the general market or index. In cryptocurrency markets, though, this correlation isn’t always present.
It’s been almost a century since its creation, but the Wyckoff Method is still in widespread use today. It is certainly much more than a TA indicator, as it encompasses many principles, theories, and trading techniques.
In essence, the Wyckoff Method allows investors to make more logical decisions rather than acting out of emotions. The extensive work of Wyckoff provides traders and investors a series of tools for reducing risks and increasing their chances of success. Still, there is no foolproof technique when it comes to investing. One should always be wary of the risks, especially within the highly-volatile cryptocurrency markets.