What is the Wyckoff Theory?
The Richard Wyckoff Theory of accumulation and distribution focuses on supply and demand for a stock, the cause and effect, and the law of effort for a stock. It tries to measure and quantify whether a stock chart is being bought and held to create an uptrend or systematically sold to create a downtrend in price. It is a method of technical analysis for trend identification.
These 5 steps are an overview of the Wyckoff method strategy for stock selection and trade entry:
1. What could be the probable future trend of a stock based on its present chart and the market price action? Is the stock market currently under consolidation or is it consistently trending in one direction? What is the current the path of least resistance for the market? Is it making higher highs, lower lows, or going sideways? For this step focus on the stock market indexes. The direction of the trend on the indexes should determine if you trading long or short will create the highest probability for success.
2. Choose stocks that are moving in the same direction as the overall market trend. During an uptrend, choose stocks that are going up more than the general market. Filter for stocks that are a moving a higher percentage up in price than the market indexes on up days and going down less than the market on down days. During a market downtrend, do the inverse, filter for stocks that are going down more than the market index on down days. Look for clear moves on stocks, don’t waste time on ones that are too volatile. Look at the trends on a stock’s charts versus the stock market indexes to see strong correlations.
3. Choose stocks with a cause of movement that is equal to or more than your minimum objective for a price goal. A primary component of Wyckoff’s stock picking and trade management was his strategy for identifying potential price targets using Point and Figure (P&F) projections for trades. In Richard Wyckoff’s fundamental law of “Cause and Effect,” the horizontal P&F count within a trading range represents the cause, while the subsequent price movement represents the effect. Pick stocks to go long that are currently under accumulation or re-accumulation and have a meaningful cause for your price target objective.
4. Is the stock ready to move and trend now? If a stock is in a trading range after an uptrend, does it look like enough supply of the stock is being sold that a short position could be the best risk/reward ratio? During an accumulation in a trading range, has the supply been traded inside the range through a low volume bounce at price support? Wyckoff used both Bar charts and Point and Figure charts for this step in his process.
5. Time your trades with the stock market index turns. Over 75% of stocks trend with the stock market indexes. You can increase the probability of winning trades by going with trades in the same direction as the trend of the overall stock market. Wyckoff trading principles try to assist in anticipating the next high probability market moves. His method tries to identify a change in the nature of price action like identifying the largest down bar with the highest volume after a long uptrend. He advised to place your stop loss at entry, then use a trailing stop if a trade went in your favor to maximize any gains until you exit.
Price Action Trading
The Wyckoff three laws of price action below:
1. The law of supply and demand determines the price direction. This is his central principle and method of trading. When demand for a stock is greater than supply, prices rise, and when supply is greater than demand, prices fall. The technical analyst can study the balance of price between the supply and demand by comparing price versus volume bars on the chart over different periods of time. This law is simple in principle but it takes time and practice to learn to both quantify supply and demand on charts and understand how to trade the supply and demand patterns through trade management.
2. The law of cause and effect is a filter for the trader to set price targets by measuring the potential magnitude of a trend breaking out from a trading range. Richard Wyckoff’s cause can be quantified by the horizontal point count in a Point and Figure chart, while the effect is the distance price moves corresponding to the point count. This law can be read as the power of accumulation or distribution inside a price trading range. How this power and force plays out in the following trend or price movement up or down is what this law is trying to project. He used Point and Figure chart counts to quantify a cause and project the extent of its effect.
3. The law of effort versus outcome gives an early warning signal of a potential change in the direction of a trend coming in the future. Divergences between the volume and the price action can many times signal a change in the trend direction. When there are many high volume/large effort but small price range bars after a large upswing in price and price fails to make a new high which shows no result, this can mean that big holders are selling shares and distributing believing a trend reversal in price is near.