Richard D. Wyckoff (1873-1934) is widely recognized as one of the pioneers of technical analysis alongside the likes of Charles Dow, Ralph N. Elliott and W.D.Gann. He was something of a compulsive student of the markets and the legendary traders of his time, like Jesse Livermore or JP Morgan. His framework has been conceptualized into the Wyckoff trading methodology, as it's commonly referred to today.
After observing and studying how the professional operators trade, he defined a set of principles, laws and trading methodologies. He did focus on the stock market, but his tool-set can be applied across markets. In addition, his approach is as applicable today as it was during his lifetime.
Below, I will aim to provide an introduction to the Wyckoff trading method. We will review the three fundamental laws and the four market cycles. In addition, I will explain trading schematics and also expand on what Wyckoff meant by the “Composite Operator”.
Wyckoff’s Composite Operator
The Composite Man or Composite Operator is a term quite frequent in Wyckoff’s published works and related literature. But who is this mystery man? Simply speaking, it’s the aggregate of the large institutions and professional traders and investors. In other words, the Composite Operator is the smart money active in the markets.
Wyckoff encourages us to view all market movements as the result of the Composite Man’s market operations. Our aim should be to trade alongside the smart money, not against it as most amateur traders do. And I will explain why this is the case later.
…all the fluctuations in the market and in all the various stocks should be studied as if they were the result of one man’s operations. Let us call him the Composite Man, who, in theory, sits behind the scenes and manipulates the stocks to your disadvantage if you do not understand the game as he plays it; and to your great profit if you do understand it.
Richard D. WyckofF
The Richard D. Wyckoff Course in Stock Market Science and Technique, section 9, p. 1-2
Composite Operator explained
So within the Wyckoff trading methodology, how does the Composite Operator manipulate the markets? And how can you identify their actions? This will all become clearer once you learn about the three fundamentals laws and market cycles, which we will explore below. But for the sake of clarity, let’s use one simple example.
Let’s say a certain stock is in a consolidation, meaning sideways price action. We correctly identify this as accumulation. Composite Man’s objective is to accumulate as much of this stock as possible before they start the markup phase.
He does this by short term manipulation of the prices, enticing the public to sell. The smart money might do this by correctly identifying a large amount of stop loss orders below the consolidation. As a next step, they induce short term selling pressure to tap into this zone of liquidity.
This in turn triggers the active stop loss orders but also sell stop orders placed under the zone by traders expecting a breakdown. The Composite Operator absorbs all these orders before stating the markup phase by inducing buying pressure.
If you have been trading for any longer period of time, I’m sure you have witnessed situations where your stop loss was triggered with a spike. And following this, price turned around and went straight in the intended direction. This was most likely the action of the Composite Operator. He saw a chance to effectively take on your position at a favorable price. In conclusion, he manipulated the market just enough to trigger yours and other traders stop losses. And then he pushed prices higher alongside other smart money.
Our competitive advantage
I guess at this stage the question arises, how can we compete with the Composite Man. We, meaning the relatively small operators, have one great advantage over the large institutions. It’s the fact that large institutions, by definition, trade substantial volumes. This leaves footprints in the markets and becomes very clear once we incorporate volume analysis into our trading.
Wyckoff kept emphasizing that as long as we understand market behaviors of the Composite Operator, we can identify trading opportunities early enough to profit from them.
The market cycle
Wyckoff defined a market cycle consisting of four distinct phases. Correctly identifying the current phase, using price and volume analysis, is one of the keys to successfully applying the Wyckoff trading method. A full market cycle consists of accumulation, markup, distribution and markdown.
Accumulation is the phase where large operators do the bulk of their buying. In other words, we can explain this as an oversold area. Typically this phase takes the shape of a consolidation, where institutions are accumulating shares in anticipation of the markup.
Markup is the next phase, where demand is greater than supply and we see an uptrend with higher highs and higher lows.
Distribution, also referred to as the overbought area, is where institutions take their profits and the preceding trend comes to a halt.
Markdown is a downtrend with lower highs and lower lows, where supply overpowers demand.
In addition to these four main phases, there are also re-accumulations and re-distributions. The key difference between a re-accumulation and distribution is that the former resolves in a trend continuation and the latter in a trend reversal.
Market cycle analysis according to Wyckoff is a simple concept, but correctly identifying a current market phase is not easy. Mastering Wyckoff schematics will aid you in this skill and enable you to enter high probability trades when an accumulation phase is about to resolve into a markup phase. And vice versa with distribution phases and short trades.
Three fundamental laws of Wyckoff trading
The Wyckoff trading methodology defines three fundamental laws aiding you in your analysis. A thorough understanding of them will help you to identify assets ready for a move, project profit targets and identify correct price and time to enter your trade.
The law of supply & demand
Prices go up when demand is stronger than supply and vice versa. Simple fact, but actionable analysis of supply and demand dynamics will take some time to master. And correctly identifying supply and demand patterns will require some experience.
There are many traders who trade supply and demand concepts and patterns exclusively. It is a very rewarding concept if used correctly.
The law of cause and effect
This law helps you to determine price objectives for your take profit levels. A cause is the consolidation phase of an accumulation or distribution. The effect is the subsequent markup or markdown. Personally, Wyckoff utilized point and figure charts for measuring profit objectives. He used the horizontal point count of the trading range and then used the same distance projected vertically as the profit target.
Point and figure charts are not commonly used today. Many Wyckoff traders have simplified this rule by looking at the vertical measure of the accumulation or distribution phase and then projecting same distance from the breakout point in order to arrive at a profit target
The law of effort vs result
In essence, this law looks at divergences between price and volume action. If there is an effort (volume on a move), the result (price action) must be in proportion to that effort. When it’s not, this needs to be considered as a potential signal for an upcoming change of character.
This law also helps you to determine if a move out of a range is sustainable or likely to fail. You’ll be able to determine future direction by incorporating volume analysis in your trading. When prices break out of a range, the question you should ask is if there is sufficient demand in the market to sustain a prolonged move. And this can be simplified by looking at relative volume on your charts. Low volume accompanying a breakout should raise warning signals. Volume needs to enter the market to push prices in the desired direction and absence of it will often signal a false move.
Wyckoff trading schematics
A Wyckoff schematic is a structure analysis of a distribution or accumulation phase. Full exploration is a topic for another post. My aim here is to provide a clear and simple to understand introduction to Wyckoff trading. So let’s take a look at a typical accumulation schematic.
There are five distinct phases to an accumulation schematic:
- 1Phase A: Stopping of the prior downtrend.
- 2Phase B: Building of the “cause”. This is where accumulation by large operators happens.
- 3Phase C: The test phase, where institutions test remaining supply and determine if the asset in question is ready for a move.
- 4Phase D: This is the uptrend within the range after a successful test.
- 5Phase E: Demand is stronger than supply and we move out of the range within an established uptrend.
Within the accumulation schematic, there are several distinct events Wyckoff traders pay attention to:
Wyckoff trading summary
Wyckoff trading is a comprehensive framework centered around the assumptions that market moves are to a large extent driven by large institutions. In other words, smart money. Correctly identifying the presence and actions of smart money enables us to trade alongside large institutions and presents us with high-probability trading opportunities. We're able to do this by utilizing volume analysis, Wyckoff schematics, supply & demand dynamics and structure.
The Wyckoff trading principles have stood the test of time. Many professional traders today use the Wyckoff principles in their trading. Including myself, as you'll see if you follow my trading analysis. That said, the approach is still not very widely followed within the retail trading community. This fact can give you a clear edge if you decide to learn and apply the Wyckoff method in your trading.