I think we should start by simply outlining Wyckoff’s Five-Step method for entering a trade, so that we have his rough framework cemented into our understanding. Once that framework is understood, we will then review it with more and more detail. This will be the process that we will continue to use, building upon previous understandings, and reviewing those understandings to insure the accuracy of the process.
The Wyckoff 5 Step Method
Step 1:
Identify the trend and the position within that trend of the general market.
Step 2:
Select those stocks that are in harmony with the market, in a bull market stronger, in a bear market weaker, using the idea of relative strength.
Step 3:
Select those stocks that have built a cause for a potential move in keeping with our goals. Use point and figure charts to determine how far the stock is likely to move.
Step 4:
Determine the stock’s readiness to move and then analyze the vertical and figure charts with the help of the Nine Buying and Selling Tests.
Step 5:
Time your commitments with a turn in the general market using the three laws that govern all market behavior.
Okay, there is a lot we can talk about here, and there is a whole lot more to come. It is important that you commit to memory these five steps. Say them out loud to yourself. It is kind of like the link-system of memorization. We will be linking may things to this frame work and it makes things a whole lot easier if you are able to repeat these five steps by route memory.
Lets take each step, one at a time and examine them.
Step 1:
Identify the trend and the position within that trend of the general market.
First of all, you need to pick one market index and use that. Things can get very confusing if you are using several different indexes. It is true that some indexes may be moving up, while others may be moving down, but you really need only one good index. If you trade a lot of stocks that are on the NASDAQ, then use the NASDAQ as your index. Watching too many indexes can tie you into a knot and cause paralysis. It is not to say that you are not looking at other indexes, but for trading purposes, when Wyckoff talks about the trend of the general market, he is talking about the market index you are using…one single index.
Now, when we talk about the position within that trend, we are talking about where the price action is relative to the trend channel. There are three types of trends, and up trend, a downtrend and a trading range. Each of these trends have specific rules for defining them. You can’t just draw trend lines all over your charts…it doesn’t work that way. The trend lines have to be valid. Most trend lines that technicians draw are not valid. We will learn how to draw valid trend lines that conform to Wyckoff’s principles.
What Wyckoff is telling us, is that when you have an up trend, and the price action is at the overbought line, it is not the time to put on a position…you need to wait until the price backs off to the support line. Again, we will examine this in much greater detail, refining these ideas greatly. For now, we need to recognize that the position within the trend is as important as the trend itself…possibly even more! We could spend a week just talking about Step 1, but our purpose is to gain a very general idea of the principles so that we can build upon solid understanding….lets move on.
Step 2:
Select those stocks that are in harmony with the market, in a bull market stronger, in a bear market weaker, using the idea of relative strength.
Okay, this is a difficult one, but I am going to give you a rough sketch. In harmony with the market means if the market is moving up, so is your stock. If the market is moving down, your stock is also moving down. However, Wyckoff wants us to pick the best of the best. So, if the market has just broken out of a trading range to the up side, you want to look for stocks that have already broken out of their trading range and are ahead of the market. The Opposite is true for a bear market…you will want to look for stocks that are falling faster than the market.
What you will be doing is visually comparing your stock to the index you are using, looking at the last two or three price swings. When Wyckoff talks about relative strength, he is talking about the strength or weakness of your stock compared to the market index you are using….Lets move on.
Step 3:
Select those stocks that have built a cause for a potential move in keeping with our goals. Use point and figure charts to determine how far the stock is likely to move.
A point and figure chart is an unusual construction that gives an indication of how far a stock, or the market is likely to move. This is a course of study in and of itself, that we will go into much detail with.
Step 4:
Determine the stock’s readiness to move and then analyze the vertical and figure charts with the help of the Nine Buying and Selling Tests.
A stock’s readiness to move is determined by any one of a number of Wyckoff principles that we will soon go over. A principle is a reflection of one or more of the three laws in action. As mentioned before, these laws are the Law of Supply and Demand, The Law of Cause and Effect, and the Law of Effort VS Result. We will go over all of this as we move through our discussions.
Step 5:
Time your commitments with a turn in the general market using the three laws that govern all market behaviors.
Here, we are right back where we started. What this step is telling us, is that we don’t want to buy a stock when the market is not ready to move. We want to time our commitment with the market so that the market will pull our stock in the right direction. If we have a stock that is ready to explode, and the market is reacting, we might not get the explosive move we were looking for. So, Step 5 brings us full circle.
Now that you have the view from ten thousand feet, we are going to drop down to about the nine thousand-foot level and take another look. We will continue this process until we need a microscope to look at the price action. The process will be to Review, Review and Review….Practice, Practice, and Practice….just like an athlete. And as we practice, remember what the famous football coach Vince Lombardi once said "practice doesn't make perfect, perfect practice makes perfect." And so we will strive with everything we do.
Okay, here we go again. I will outline what we are going to review and I will provide links to each subject.
Step 1:
Identify the trend and the position within that trend of the general market. To do this, we are going to need some special tools. The tools we will use for identifying the trend are:
Trendlines (normal and reversed),
1/2 way points,Thrusts,and Figure Charts.
Additionally, we will also use several other principles that will heip us identify trends. They are:
Preliminary Supply,
Buying Climax,
Automatic Reaction,
Secondary Test,
Preliminary Support,
Selling Climax,
Automatic Reaction
and Secondary Test.
Okay, so now we are going to dive into Step 1. We have a number of tools for evaluating the health of the trend (trend lines, ½ way points, thrusts, figure charts), and several principles that we are going to use to assist us in finding the trend (Preliminary Supply, Buying Climax, Automatic Reaction, Secondary Test, Preliminary Support, Selling Climax, Automatic Rally and Secondary Test), as well as the use of three never changing laws that govern all market behavior: The Law of Supply and Demand, The Law of Cause and Effect and The Law of Effort VS Result. This paragraph contains a basket of ideas that we will need to review before going any further in Step 1.
Lets examine the three laws the govern all market behavior as it will help us as we move through Step 1 in more detail.
The Law of Supply and Demand states:
When there is an excess amount of something (supply) the value of that item is reduced in order to draw in the demand needed to absorb that supply.
Or, if there is a scarcity of something, then the value of that item will increase to create the supply that will meet that demand.
For example, if I am selling ten laptop computers on-line for $2000, and only three people that want to buy them, the Law of Supply and Demand states that if I reduce the price, I will draw in (attract) more buyers. I will keep reducing my price until I have met the supply (sold the ten computers).
If on the other hand, I have one hundred people that want to buy my ten computers…I am going to raise my price until I am left with only ten people who want to buy them…and that will be at the highest price I can get. eBay auctions are based on the law of Supply and Demand.
The Law of Cause and Effect states:
In order for there to be an effect (change in price), there needs to be a cause (building up on figure chart). The effect will be in direct proportion to that cause. As Wyckoff traders, we need to look at our Point and Figure Charts and only expect moves if a sufficient cause has been built. We will review techniques on how to measure that cause and project how far the stock is likely to move (effect). If the stock indicates that it is likely to move, but there is not sufficient cause built to justify a trade, we don’t take the trade regardless of how good the stock looks.
The Law of Effort VS. Results:
Simply state, if there is an effort, the result must be in proportion to that effort and can not be separated from it. If it is not, it is an indication of other principles in action. Think of effort as the volume on a move, and the result is the corresponding price action. These two should be in harmony. If you have a lot of volume, you should see a lot of move, if you don’t…why? What is happening? This is where we become the detective, use our tools, evaluate that price action (result), with the corresponding volume (effort), and make some deductions based on the “balance of probabilities”.
What is a Principle?
A principle is a comprehensive and fundamental law, doctrine or assumption. It is an unchanging rule. The three laws just mentioned are principles. They are never changing. We have another group of principles that are really a reflection of one or more of the three laws. We use the following principles to help us detect the three basic laws, and by doing so make an assessment on market conditions. Before we list these other principles, remember Wyckoff’s admonishment “Study your charts not with an eye to comparing the shapes of the formations. Rather study your charts or tape from the view point of the behavior of the stock, the motives of those who are dominate in it, and the successes and failures of buyers and sellers as they struggle for mastery on every move.”
The reason why I brought your attention to Wyckoff’s admonishment is because when we review the following principles, you might think of them as price patterns….Don’t. It is true that there are some common characteristics with each of the following principles, but that is where it ends. They can take on a Varity of shapes. If you are just looking for shapes, you will miss out on important clues.
For your convenience, I have listed the principles in the library.