Practical Approach to use Wyckoff Method
Wyckoff theory is one of the most popular theories in technical analysis. The concept seems to work even today and hence many study his method and try to implement in their trading. I would not be covering the details of the methods here. My focus will be on how can we understand the concept better and try to use some of the basics of this strategy in our strategy. The method in itself is very difficult to master as there can be lots of variations and sometimes the market will show fake moves before giving an actual breakout. Lets try to cover some of the basics quickly.
Wyckoff Price cycle
This theory proposes that the prices moves in 4 phases.
Accumulation: Prices moves sideways and large players try to accumulate the stocks without letting the prices go beyond a range. This phase is highly range bound and there will be many fake breakouts. The low will be tested multiple times and will trap traders that are hoping for a continuation in trend. There are many nuances to identify the accumulation zone but it is very difficult to spot an exact setup that is being shown in text books. Often people wait for the exact setup to occur but most of the time either the trend is missed or they get caught in a fake breakout.
Markup: In this phase the prices will trend upwards. This is the phase where the long traders have the highest chance of being in profit. Since the prices are in strong up trend, any entry method will help here.
Distribution: This phase is similar to accumulation phase as the prices will be moving sideways but this time the smart players will unload their longs and might create short positions. The consolidation zone has schematics similar to accumulation phase . The only difference would be that there is higher amount of selling happening.
Markdown: Markdown phase will be characterized by price moving downwards in a trend. The trend will continue till it reaches an accumulation zone or distribution zone.
Market do not move sequentially!
We need to understand the market might not move in these phases sequentially. What I mean is that after a trend there can be a consolidation and again a markup and again a consolidation. See the image below, the market went to accumulation phase from markup phase and them again went in markup phase. Life would have been much easy had these phases followed a specific sequence. But like all things in stock market the sequence of these phases is also not certain.
Problems with trading in accumulation and distribution zone.
The biggest problem with trading in an accumulation zone is that the confirmation of prices being in a trading range happens only after few swings are formed.
Look at the image below. The formation of distribution phase creates lots of pattern before actually making the standard Wyckoff schematics. As a trader who wants to be on the right side of trend, taking a counter-trend trades early in the accumulation is difficult. Even with in the trend entry, the support formation is confirmed after the first swing. But this support confirmation does not help much because the next time it approaches the support, the trader might suspect an M pattern in formation. We can see similar scenarios when the prices are in the distribution zone. In the image below, we can see all the intermediate structures. These structures are well known in trading and create a lot of confusion. Also, it is rare to find a typical accumulation/distribution zone as mentioned in the standard literature. Additionally, even if we decide to enter trade when the support or resistance is reached, the RRR is very subjective to the candle close.
Wykoff method becomes specifically difficult with intraday trading. In accumulation/consolidation zone, the intraday movement is very random. Taking decisions basis this method in an accumulation/consolidation zone does not hold a any edge in intraday trading.
Markup and Markup down zones are easy to trade.
Wyckoff did realize this fact of difficulty in trading in the accumulation/consolidation zone and hence suggested that we should trade in stocks that are in trend and are moving faster than its fellow stocks. The logic behind this advice is pretty obvious. We have lots of indicators and methods to identify a trend. From moving averages to RSI to MACD, everything would give a good entry in trending market. Moreover, the RRR is superior with long one-sided moves in trending market.
How to trade trends using Wyckoff method?
Wyckoff method has very specific criteria when deciding whether the market is trending or not. The trend is always confirmed once the support or resistance is broken. In a way, the method adds the consolidation pattern before a trend starts. This approach reduces the Wyckoff method into a range breakout strategy.
If we see the consequence of approximating the Wyckoff method as a range breakout strategy, we will be able to bring many other strategies under the same umbrella. Rounding tops and bottom, pole and flag, pennant, Darvas box strategy, etc., can be seen as trading strategies that focus on the trend catching after a consolidation ( be it accumulation or distribution).
The convergence of so many trading strategies does indicate towards the merits in the approach. Also, to follow a strategy that brings consensus among technical analysts increases the probability of being on the correct side of the trade.
However, entering a trade basis Wyckoff method is easier said than done. There are factors like strength of trend, momentum, optimal entry, stop loss, etc., before getting into a trade. We will cover these topics in other articles. However, we did get insights into a time tested method. We can learn from the successful systems in the past and improve our own systems.
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