“In the long term, we’d all be dead.” It’s a very common phrase used by technical analysts to take a jibe at long-term investors. Similarly, long-term investors are often found criticizing the traders. Me? I am neither. I believe an efficient investor is one who sees both these techniques in context. If I wish to buy a crypto for long term, why not enter at the best price? Similarly, if the technicals aren’t favourable, isn’t it smart to exit and re-enter?
So if you belong to a similar league, we dedicate this blog post to you. We are going to talk about one of the most effective techniques to pick winning stocks, the most advantageous times to buy them, and the most effective risk management. Enter, Wyckoff’s Theory. What is it? How can you put it into practice? The foundation et all. We’ve got you covered. Read on!
What is Wyckoff Theory?
In the 1930s, a man named Richard Wyckoff came up with a series of principles and strategies to invest in the stock market. The theory held its ground till modern times; hence, traders and investors started applying it to other financial markets like crypto.
Wyckoff theory outlines some key trends in price action which are determined by the cycle of accumulation and distribution. Four phases outlined in this theory are as follows:
Wykoff also came up with certain rules to be used along with these phases to predict the significance of a price within the broader spectrum of uptrends, downtrends and sideways market.
Who was Richard Wyckoff?
Richard Wyckoff (1873-1934) was a famous stock market trader and investor. He is considered to be the pioneer of the technical method to analyze the market. Using his approach, Wyckoff managed to predict a point where the risk and reward were optimal for entering/exiting a trade.
Apart from that, Richard was also a proponent of risk management. Hence, the stop loss was a part of each of his techniques.
Talking of multiple revenue streams, Richard Wyckoff also founded ‘Wall Street Magazine’ in 1907.
As Wyckoff accumulated wealth, he wanted to help others navigate the stock market as well. So he resorted to teaching, education and publishing media reports.
What Purposes Does the Wyckoff Method Serve?
The Wyckoff method serves as a theory to define how and why the stock and commodity markets move in a particular direction. Traders and investors use the Wyckoff method to determine market trends. It can help its users find more profitable trades.
Rules in Wyckoff Theory: The Foundation
Wyckoff’s rules are derived from his study and experience of charting the market. These rules are general guidelines and principles for traders to look out for.
The market and individual securities do not behave in the same way twice.
Known as a shapeshifting phenomenon in modern-day technical analysis, this always stays one step ahead of profit-taking. This rule states that the trend emerges in buckets of similar price patterns that show variations in size, detail and extension. Every such bucket is different enough from the previous one to confuse the market.
So for those of you who predicted markets to bounce back in the same way during the second wave of Covid, here’s an eye-opener for you.
The significance of price movement reveals itself only when it is compared to past price behaviour.
Well, it is just another way of saying that prices should never be evaluated in isolation. If you look at the price movement today and try to predict tomorrow, you are most likely to fail due to lack of context.
Prices should always be seen in correspondence to the prices at the same time yesterday, last week, last month, last year and so on.
These simple rules provided powerful observations for trend recognition. As per Wyckoff, there are only three types of trend: Uptrend, Downtrend and Flat. Secondly, only three types of time-frames: Short-term, long-term and intermediary term. Each of these trends varied significantly in different time frames.
The Four Phases of Wyckoff Market Cycles or Price Cycles
Wyckoff market cycles are developed on the basis of Wyckoff’s rules we discussed above. These are used by traders and investors to predict the general direction of the market along with the signs of reversal. It also points them towards hints of whales accumulating or selling positions.
The four phases of Wyckoff market cycles are accumulation, markup, distribution and markdown. These phases are used to guess the market sentiment and hence predict the direction of the price of a stock or commodity.
Let us discuss each of these phases in detail:
Accumulation marks the beginning of a new cycle that determines a trading range. A trading range defines as high and low which act as resistance (difficult to surpass that price) and low which acts as support (it’s hard for the price to go below that). The lows, also known as the failure point, mark a selling climax.
Wyckoff created a fictional entity called the ‘composite man’ in the stock market. He suggests that we should view the stock market as run by a single person or operator. In essence, this composite man refers to the whales or wealthy investors/institutions. It is in their best interest to steer the market in a way that they can always buy low and sell high. If observed closely, one can predict the movement of the composite man.
A composite man always accumulates or takes positions before others in the market. This is done strategically to make sure that the ‘buy’ is not reflected in the prices. Markets show a sideways movement during the accumulation phase.
Markup is defined by the slope of the upward trend. Each markup will have the following characteristics:
- Pullbacks: These are minor visits to the newer support, offering a buying opportunity for the investors. Wyckoff calls this throwback. I wonder what his reaction would be watching the social media influencers using this term for posting their old photos.
- Correction: It is the moment of steeper pullbacks.
- Re-accumulation: Small consolidation patterns, interrupting the markup are called re-accumulation phases.
A composite man would sell his positions to the people who are entering late into the market. This is again notified by a sideways movement until the demand exhausts. A characteristic marking the start of the distribution phase is the failure to form higher highs.
To understand the distribution phase better, think of it as the exact opposite of the accumulation phase. Just like the latter, distribution is also range bound. There are often pullbacks to the previous resistance and can be used to short the commodity for profit.
Exact opposite of markup, markdown is measured by the slope of the downward trend. Similar to uptrend, downtrend also has re-distribution phases where the market tends sideways.
Another key feature of a markdown is bull-trap or dead cat bounce. It is the moment of short jump in the prices where traders mistake it for reversal and hence get trapped.
The Three Laws of Wyckoff:
All of us have heard of the three laws of Newton. While they help us understand the universe better, it is time to talk about the three laws of Wyckoff. These laws help us explain market events.
A. The Law of Supply and Demand:
This law is not exclusive to Wyckoff and resonates with the basic principles of economics. The first law states that the prices go up when supply is lesser than the demand and vice-versa. It also states that if demand is equal to the supply, market moves sideways and the volatility is low.
Investors following the Wyckoff law of supply and demand visualize it with the help of wick charts. They evaluate price action with volumes to gauge the supply and demand.
B. The Law of Cause and Effect:
The second law states that the difference between supply and demand is not random. In fact, they are driven by specific events. Simply put, any movement in the market would have rationale behind it.
In Wyckoff’s law, a period of accumulation (cause) eventually leads to an uptrend (effect). Oppositely, a period of distribution (cause) is followed by downtrend (cause).
C. The Law of Effort vs. Result:
The final law of Wyckoff states that the change in the price of an asset is a result of an effort, which is represented in the trading volume. In other words, if the price of an asset goes up along with an upward trend in the volumes, the trend is likely to sustain. Alternatively, if the divergence between price and volume increases, we are due for a reversal.
For example, in the current bear market, say Bitcoin price goes sideways along with very high volume, it shows that a lot of Bitcoin changed hands but the price action was not significant. This hints at a nearby reversal.
Wyckoff 5 Step Method for Investors:
Wyckoff method is devised using the laws, rules and price cycles we learnt above. Any investor willing to jump into the market can apply this method to predict the outcomes to a certain extent. Let us discuss the five steps involved in the application of this theory.
1. Try to predict the current market direction and most likely future turn of events. Using the supply and demand, predict if the market is positioned to go up from here or tank down.
2. Select stocks or crypto that follow similar market trends. Ideally, you would need crypto that bounces back harder during the upswings and shows a relatively lower downside during the downtrend.
3. Select the stocks or crypto which is in the accumulation phase. Simply reverse it and check if the asset is in the distribution phase in case you are preparing to sell or short. These cryptocurrencies showcase the potential of meeting your target price.
4. Check out the volumes and price movement of the stock and overall market before taking a position. This will increase the probability of your hypothesis being correct.
5. Time your trade in such a manner that you are in a position to leverage the larger market swings. In other words, buy a stock if you feel that the market will reverse or alternatively, sell if your analysis suggests that the market will fall.
Limitations of the Wyckoff Method:
Wyckoff method is used by institutions and individuals to refine their trading strategies. It has definitely stood against the test of time and is still a relevant method of technical analysis of securities and stocks.
While the overall methodology has helped a lot to formulate their individual strategy, the finer details are still subjective. Furthermore, it would be difficult for a newbie to identify patterns using the Wyckoff method. It may require years of practice to gain expertise.
To top it off, the Wyckoff method can be used for high-frequency trading. It works best for short term trades and hence might not be suited if that is not your angle.
Is Wyckoff Strategy Profitable?
While the learning curve is steep, if applied properly, Wyckoff’s strategy can help you generate profits. Once you successfully figure out the way to predict highs and lows, it should be a smooth ride.
But what if you do not have the time or patience to learn and practice? Don’t lose hope yet. Coinsets by Mudrex can allow you to take positions in themes instead of individual cryptos. This not only saves a lot of time but also hedges your risk by diversifying within the theme.
Well, the essence of trading is context. The more you practice and learn, the better you can contextualize the market conditions. While Wyckoff strategy is the beginning, a lot more strategies can be explored after that to further strengthen your cause.
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Until next time..
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