Wyckoff Trading Strategy — What Is It? (Backtest)
Last Updated on October 17, 2022
As a trader or investor, you want to know the best ways to pick winning stocks, the most advantageous times to buy them, and the most effective risk management techniques to use. This is where the Wyckoff strategy comes in.
The Wyckoff strategy is a series of market classification, rules, and methodology developed by the legendary technical analyst, Richard Wyckoff, which investors can use to determine what stocks to buy and when to buy them. It consists of the Wyckoff market cycle, Wyckoff’s laws, and the Wyckoff Method.
To learn the Wyckoff method to stock trading, read on! After we explain the Wyckoff strategy, we make a backtest to see if the theory works in practice.
What is the Wyckoff strategy?
In the early decades of the 20th century, Richard Wyckoff, a renowned market technician, wrote about financial markets, documenting his observations on price action. His pioneering approach to technical analysis survived into the modern era and is now known as the Wyckoff strategy.
The Wyckoff strategy is a series of market classification, rules, and methodology developed by the legendary technical analyst, Richard Wyckoff, which investors can use to determine what stocks to buy and when to buy them. His technical analysis approach has been distilled into the following elements:
Wyckoff’s price cycle
The Wyckoff market cycle is the most popular element of the Wyckoff strategy.
It’s based on Wyckoff’s observations of supply and demand. It explains how and why stocks and other securities move and the significance of price within the broad spectrum of uptrends, downtrends, and sideways markets.
The price cycle shows that the market moves in a cyclical pattern of four distinct phases — accumulation, markup, distribution, and markdown.
In essence, the phases represent the behavior of traders and can reveal the direction of a stock’s future price movement. Investors and traders use Wyckoff’s market cycle to identify a market’s direction, the likelihood of a reversal, and when large investors are accumulating and selling positions.
Here are the four phases in detail:
- Accumulation phase: The market cycle begins with an accumulation phase. Here the price is in a trading range, as institutional investors are quietly accumulating long positions in the stock. With time, they increase their buying and drive demand, and as more interest develops, the trading range displays higher lows as prices position themselves to move higher. Eventually, the price pushes through the upper level of the trading range.
- Markup phase (uptrend): After breaking out of the trading range that characterizes the accumulation phase, the price shows a consistent upward trend, which is known as the markup phase. In this phase, pullbacks to new support offer buying opportunities that Wyckoff calls throwbacks (what investors now call buy-the-dip). Small re-accumulation phases interrupt markup. These are price consolidation patterns within an uptrend. There are also steeper pullbacks which Wyckoff calls corrections. The markup phase continues with upswings and corrections/consolidations until the price fails to generate new highs.
- Distribution phase: The failure to generate new highs signals the start of the distribution phase, which is characterized by a range bound price action similar to the accumulation phase. It is a period when smart money is taking profits and heading to the sidelines. With sellers eventually gaining the upper hand, the horizontal trading range in this phase will display lower price tops and a lack of higher bottoms. This leaves the security in weak hands that are forced to sell when the range fails in a breakdown that begins a new markdown phase.
- Markdown phase (Downtrend): The markdown phase is a time of greater selling, which drives the price lower. This bearish period generates throwbacks to new resistance that can be used to establish timely short sales. Wyckoff calls steep small rallies within the markdown phase corrections, using the same terminology as the uptrend phase. There are also small consolidations or redistribution segments, where the trend pauses while the security attracts a new set of positions that will eventually get sold. The markdown phase finally ends when a broad trading range or base signals the start of a new accumulation phase — the beginning of a new cycle.
Wyckoff’s market cycle and his chart-based trading method are based on three fundamental “laws” that govern many aspects of his analysis, such as determining the market’s and individual stocks’ current and potential future directional bias, selecting the best stocks to trade long or short, identifying the readiness of a stock to leave a trading range and projecting price targets in a trend from a stock’s behavior in a trading range. Let’s take a look at each of those laws:
1. The law of supply and demand
This principle is central to Wyckoff’s method of trading and investing, as it determines the price direction — when demand is greater than supply, prices rise, and when supply is greater than demand, prices fall.
You can study the balance between supply and demand by comparing price and volume bars over time. On the intraday timeframe, the volume-weighted average price (VWAP) comes in handy. While this law is deceptively simple, it takes time to learn how to accurately evaluate supply and demand on bar charts and use it to your advantage while trading.
2. The law of cause and effect
This law helps you to set price objectives by gauging the potential extent of a trend emerging from a trading range. The law manifests as the force of accumulation or distribution within a trading range and the subsequent trend or movement up or down. The point and figure chart counts are used to measure a cause and project the extent of its effect. You can measure Wyckoff’s “cause” with the horizontal point count in a point and figure chart. The “effect” is the distance price moves corresponding to the point count.
3. The law of effort versus result
This provides an early warning of a possible change in trend in the near future. When there is a divergence between volume and price, it could signal a change in the direction of the price trend.
For example, when there are several sessions with huge volume (large effort) but small price bars after a substantial rally, with the price failing to make a new high (little or no result), it may suggest that smart money is unloading shares in anticipation of a change in trend.
The Wyckoff strategy and method
This is a five-step approach to stock selection and trade entry distilled from Wyckoff’s trading methods. The five steps can be summarized as follows:
- Establish the current position and probable future trend of the market: You should find out whether the market is consolidating or trending. Then analyze the market structure, including the supply and demand levels, to find out the likely direction of the market in the near future. With this assessment, you can decide whether to be in the market at all and, if so, whether to take long or short positions. You may use both candlestick charts and Point and Figure charts for your analysis.
- Choose stocks in harmony with the trend: Compare individual stock charts with that of the most relevant market index to determine the ones to trade. If the general market is in an uptrend, select stocks that are stronger than the market. Look for stocks with greater percentage increases than the market during rallies and smaller decreases during reactions. In a downtrend, choose stocks that are weaker than the market. When confused, leave the stock entirely and move on to the next one.
- Choose stocks with a “cause” that equals or exceeds your minimum objective: In 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. If you want to take long positions, choose stocks that are under accumulation or re-accumulation and have built a sufficient cause to satisfy your objective.
- Be sure of the stocks’ readiness to move: Only pull the trigger when there is enough evidence that the stock is about to move. So, if you are going long, you must wait for the stock to break out of the accumulation trading range. Likewise, if you are planning to go short after a distribution phase, be sure that the price has broken below the support of the distribution trading range. Using spring and upthrust patterns might help reduce the likelihood of a false breakout.
- Ensure you time your commitment with a turn in the stock market index: Most stocks tend to move in harmony with the general market. So, the odds of having a successful trade are much higher if you have the power of the overall market behind it. Certain Wyckoff principles help you anticipate potential market turns. For example, the nature of the price action — such as the largest down-bar on the highest volume after a long uptrend — can tell if the market is about to turn. Also, the application of Wyckoff’s three laws also helps here. Be sure to put your stop-loss in place for all your trades. Trail your profits as appropriate, until you close out the position.
Wyckoff trading strategy backtest
The Wyckoff trading strategy is very difficult to backtest and lacks specific trading rules and settings. It is, of course, doable, but we argue it’s not worth the time nor the effort.
Some of the Wyckoff strategy is a pattern within a larger pattern. This is hard to put into trading rules, and it needs to be broken down into smaller “units”. Additionally, you need to program and code volume, further complicating the process.
In general, because of the lack of objectivity, we believe classical technical chart patterns might be a dead end for traders. Why would you spend time on something that is not backtested where you have no clue if the pattern is profitable or not? How do you know a pattern is profitable if you have not backtested it?
A backtest doesn’t guarantee anything, but at least you know it has been profitable in the past. If the pattern has not been profitable in the past, you can safely skip it and not waste any more time. Trading is about having a portfolio of trading strategies, not having one or a few subjective classical chart patterns. There is no best trading strategy because you need many to smooth returns.
(If you are new to backtesting and it looks like a daunting task, you might be interested in our backtesting course.)
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The Wyckoff trading strategy (method) – conclusion
The Wyckoff trading strategy has been around for over a century, and still we are not able to find any relevant backtest on the internet. Moreover, we have yet to see a successful trader that uses the Wyckoff method. If you are serious about trading, we recommend a completely other approach: quantitative trading via backtests.