Wyckoff market cycle

In early 1900s Richard Wyckoff developed his understanding of the buying and selling convictions of large traders through the patterns their activity left on prices. Wyckoff proposed a four-stage market cycle, and this method is still relevant today, because Wyckoff cycle is just an expression how human psychology reveals itself in the marketplace.

1. Accumulation. A sideways range where large players buy, skill allows to to that carefully without moving the price. The public is unaware of what’s going on, the market is off the focus.
2. Markup. In the uptrend the public becomes aware of the movement and focus the attention to the market, their buying pressure shift the price higher. Large players who bought in the accumulation may sell some of their position into the strength of the uptrend.
3. Distribution. Smart money players sell the rest of their holdings to the public and may establish short position, the public still thinks uptrend will resume.
4. Markdown. In the downtrend smart money who still short the stock may buy back some into the weakness. The public realizes that uptrend is over and they sell, and their panic sells often indicates the end of the downtrend.

Four trades

The Wyckoff market cycle is an idealized representation of the typically noisy market structure, but it serves as a foundation for a straightforward categorization of technical trades. These trades fall into four main categories: two trend trades – trend continuation and trend termination, and two support and resistance trades – holding and failing. Every technical trade aligns with one of these categories:

• Trend continuation. Identify a market in an established trend and executing trades aligned with that trend
  • The most common approach is trading pullbacks within the trend, positioning for the next leg of movement
  • Breakout trades can also serve as trend continuation strategies, aligning with the trend’s direction
  • Additionally, traders may aim to enter during the initial formation of a new trend

• Trend Termination. Using precise terminology is crucial here. While it may be tempting to label these trades as “trend reversals,” this term can create misleading expectations. If you approach these trades expecting a trend reversal, you might anticipate the market to immediately shift into a trend in the opposite direction. However, true trend reversals are rare. More commonly, a successful trend termination trade involves selling near the high and observing the market cease its trending behavior. In this context, the trend simply stopping is considered a win. Anything beyond that is an added bonus, so it’s essential to align your expectations accordingly
  • Trend termination trades occur at key points in the cycle where an uptrend halts and transitions into distribution, or conversely, where a downtrend ends and shifts into accumulation.
  • Some traders focus on identifying overextended points within established trends and execute counter-trend scalps, aiming for brief and quick reversals. However, developing traders are generally advised to steer clear of these counter-trend strategies, as they can detract from maintaining focus on the bigger market picture.
  • These are spots where short-term downtrends (pullbacks) within an uptrend become overextended, prompting traders to take long positions against these lower time frame downtrends. In this scenario, the trader is counter-trend on the lower time frame but aligned with the trend on the higher trading time frame. Whether this is categorized as a trend continuation or trend termination trade depends on the trader’s perspective and chosen time frame. The key is to maintain consistency in how these trades are defined and approached.

• Support or Resistance Holding. There is some overlap among these trade categories, allowing trades to occur at multiple points within the market structure. While most support or resistance trades are expected in accumulation or distribution zones during sideways market movement, a trader could also execute with-trend trades by buying support within a trend. Are these trades classified as trend continuation or support holding? The answer is both, emphasizing the need for a well-structured classification system that aligns with a trader’s approach. Your trading rules and patterns serve as tools to organize price action and market structure and must resonate with your perspective.
  • Support rarely holds cleanly. Breaks below support often strengthen it as they shake out buyers who then reposition when it becomes evident that the drop was a fake-out. For shorter-term traders, this introduces key considerations. How will you handle trades around these levels, knowing they are prone to false breaks? Will you exit your position when the level drops, accept small frequent losses, and re-enter if support holds? Alternatively, will you scale in with smaller positions, add if the level drops, and accept occasional large losses on full positions when the support fails? If scaling in, another issue arises: easy wins may not be at full size because you couldn’t fully position near the bottom of the range. By the time support proves itself, the market may have moved away from the level, increasing the required stop loss. These challenges mean that support/resistance holding trades often have the lowest reward-to-risk ratios. Support is defined by an imbalance of buying pressure, yet the market typically remains in relative equilibrium just above support. This equilibrium creates suboptimal conditions, leading many traders to avoid trading directly in these zones.
  • A noteworthy exception is the subset of support/resistance holding trades involving failed breakouts. These setups tend to offer high-probability opportunities. When the majority is positioned incorrectly, the potential for dramatic moves increases significantly, making failed breakouts particularly powerful setups. 

• Support or Resistance Breaking or Failing. Support and resistance breaking trades, often referred to as classic breakout or channel breakout trades, typically occur at the conclusion of accumulation or distribution phases. These trades signify the transition out of these phases as support or resistance fails, propelling the market into a trending phase. Breakouts can also occur within trends, often as lower time frame breakout entries that align with the broader trading time frame’s trend pattern. A common challenge with breakout trades is their high failure rate. Breakout zones are often characterized by heightened volatility and reduced liquidity, which increases trade risk. These areas are also highly visible on charts, attracting significant market attention and leading to crowded trades. While the associated volume and volatility can create opportunities, they also introduce dangers. Execution skills are particularly critical in breakout trades, as slippage and thin market conditions can erode a trader’s edge.
  • Despite these risks, breakout trades can offer exceptional reward-to-risk ratios. However, traders must remain mindful that actual losses, especially in short-term trades, can sometimes far exceed the intended risk, complicating position sizing and risk management. This is not an inherent flaw but a factor that must be integrated into a trader’s overall strategy. Patterns preceding successful breakout trades can provide clues and enhance trade setups. For instance, the best resistance-breaking trades often stem from large-scale buying imbalances, evidenced by the market forming higher lows into the resistance level before breaking out. Conversely, breakouts driven primarily by small traders aiming for quick profits in volatile conditions are less reliable and lack the support of larger-scale patterns.
  • In ideal breakout scenarios, traders who miss the initial move may feel compelled to enter as the breakout unfolds over days or weeks, creating sustained buying pressure and favorable momentum for the trade. Traders specializing in breakout strategies often dedicate significant time to studying these setups, building watchlists of promising opportunities, and preparing for trades in advance. Conversely, executing unplanned, reactive breakout trades is rarely a sustainable approach to long-term success.

Summary

These four categories of trades offer a robust framework for analyzing technical trades. This system is simple, valid, and consistent, making it nearly impossible to encounter a trade that does not fit within these classifications. While some trades may straddle multiple categories, especially when considering the complexities of multiple time frames, this flexibility enhances rather than diminishes the system’s utility. It is not a rigid or artificial construct but a dynamic framework designed to adapt and evolve alongside your trading style and understanding of market behavior.

Taking a broader perspective, this cycle mirrors ideas from certain branches of Eastern philosophy, which suggest that all observable phenomena arise from the interplay of two opposing primordial forces. These philosophies assert that neither force can fully dominate the other; when one appears to prevail, it carries within it the seeds of its opposite. In the financial markets, buying and selling pressures represent these twin forces. When buying pressure seems strongest, the end of the uptrend often looms. Similarly, when selling pressure appears to overwhelm, the conditions may be ripe for a reversal into an uptrend.

This interplay underscores the importance of developing the ability to stand apart from the crowd. To achieve this, traders must cultivate a deep understanding of the actions and emotions driving the market participants. By observing the crowd with clarity and objectivity, traders can identify opportunities others might overlook, positioning themselves strategically amidst the market’s constant ebb and flow.