How to trade the Wyckoff pattern in Forex

Richard Wyckoff is considered one of the pioneers of technical analysis. After building significant wealth in the early 20th century, he later shared the core ideas of his method in his books. The concepts are simple to understand, but mastering them takes practice. In this article, we'll dive into Wyckoff’s theory and look at how it can be applied in the Forex market, focusing on the key stages of the Wyckoff cycle.

What is the Wyckoff method?

Richard D. Wyckoff suggested that all markets move in cycles. In his book 'Studies in Tape Reading', he outlined a four-stage cycle that the market follows. The chart below provides a visual representation of his method.

1. Accumulation
2. Markup
3. Distribution
4. Markdown

We’ll consider the method itself in more detail further in the article.

Now, let’s take a closer look at Richard Wyckoff himself—an influential investor and stock market analyst from the early 20th century, whose principles are still relevant to all financial markets, including Forex.

As a young man, Wyckoff began working on the stock exchange, where he interacted with traders and brokers, studying rumors and the reasons behind market failures. He concluded that a trader’s success doesn't rely on news, as the market quickly incorporates it, leaving little opportunity for profit. While rumors can sometimes be profitable, they’re hard to verify, and predicting their accuracy is nearly impossible.

Wyckoff advocated for focusing on objective market data: asset price, trading volume, and key levels and trends that reflect important trading information. He developed a trading system based on the idea that large market participants—those trading significant volumes of an asset—must realise their positions, just like everyone else.

These larger participants need to gauge the demand from the 'crowd', carefully manipulating the price to avoid pushing it too high or too low, in order to maximise profit at current price levels.

In this dynamic, experienced traders go up against smaller ones, and price movements tend to follow a predictable pattern: while the market often moves sideways, it regularly shifts to levels above or below the norm.

The Wyckoff method is based on three fundamental laws:

• The law of supply and demand: This law states that when demand increases, prices rise, and when demand decreases, prices fall. A price increase signals a surge in buyers, while a price decrease signals an influx of sellers. In Wyckoff’s method, graphs are used to analyse the impact of these causes. He proposed setting trading targets based on the length of accumulation and distribution phases. This helps traders anticipate a rise in market volume following a period of price consolidation or breakout.
• The law of cause and effect: According to this law, specific events alter supply and demand, leading to either an uptrend or a downtrend. Traders use this law to set profit targets. Wyckoff highlighted this as one of the most crucial principles in financial markets. The law shows that if demand exceeds supply, prices will rise, indicating increased buying interest. Conversely, if demand is lower than supply, prices will fall, showing less interest in the asset.
• The law of effort vs. result: This law suggests that a discrepancy between price movement and trading volume signals a potential trend change. If price and volume are in harmony, the trend will likely continue. However, if there’s a mismatch, the trend could reverse. For example, in the Forex market, after a prolonged bearish trend, a surge in volume with minimal price movement suggests a shift is coming. The high volume indicates strong market effort, while the lack of significant price drops points to the end of the downtrend.

Additionally, Wyckoff introduces the concept of the 'composite person,' also known as the 'operator.' In Wyckoff's framework, this refers to the collective force that drives the market's movement. For simplicity, it’s portrayed as a single entity, though in reality, it represents many market participants—such as major investors and institutional players. The composite person behaves quite differently from the average trader, who often experiences losses. As a result, the key task for a successful trader is to understand the operator's intentions and act accordingly.

The Wyckoff market cycle

The price goes through four stages (phases) of the cycle under the influence of the actions of large and experienced participants: accumulation, markup, markdown, and distribution.

1. Accumulation
2. Markup
3. Distribution
4. Markdown

Let's consider these phases in detail.

Phase 1. The Wyckoff accumulation is a sideways phase where large participants accumulate long positions, preventing significant price movements.

Phase 2. Markup—upward momentum is a classic rising trend with rising lows and highs. At this time, securities attract the attention of uninformed traders (the 'crowd'), and experienced traders fix a part of the profit without holding back the price.

Phase 3. The Wyckoff distribution is an inverted (mirror) version of Phase 1, i.e., it has the opposite logic: large participants gradually sell off ('unload') their current assets.

Phase 4. Markdown—downward impulse. The pressure of unprofitable positions leads to their forced closing, which causes a fierce market decline due to excessive supply. At this point, experienced participants can repurchase assets.

How to identify the Wyckoff phases

There are several steps to determine the phases. Let's look at them in more detail.

Accumulation phase

At the accumulation stage, the market shows signs of a possible change in trend direction. At first, the preliminary support (PS) appears as the first sign that buyers are showing interest after a period of bearish trend. The trading volume increases, and prices slow down. The SC follows it—the sales climax, a period with a massive dumping of assets on the market, which often signals the end of the downtrend. After the SC, it is worth paying attention to the AR—the automatic rally. This rapid and often sharp price recovery usually occurs with lower volume. Then, the market goes through the ST—the secondary test. Prices return to the SC lows with less volume to test if the selling pressure has eased.

The chart below describes the following phase.

1. Preliminary Support (PS)
2. Sales Climax (SC)
3. Automatic Rally (AR)
4. Secondary Test (ST)
5. Support
6. Resistance
7. Spring

Finally, look for spring—a short price movement below a trading range that quickly reverses. It could be the last bear trap before the growth phase begins.

Distribution phase

The Wyckoff distribution phase signals the possible end of an uptrend. It starts with a pre-bid (PSY), the first sign of selling pressure after an uptrend characterised by increasing volume and slowing price growth. It is followed by the buying culmination (BC), a period of active buying with very high volume, which often signifies the end of an uptrend. After the BC, watch for the automatic reaction (AR), a rapid and frequently sharp decline that usually occurs on lower volume. The market then undergoes the secondary test (ST) when the price returns to the BC highs on lower volume to see if the buying pressure is exhausted.

Finally, pay attention to the uptrend after distribution (UTAD), a short move above the trading range that quickly reverses and often serves as a last trap for bulls before the start of the discount phase. Once you have identified the phase of the Wyckoff pattern, you can move on to trading.

We will discuss this a little later. First, let's focus on this technical tool's advantages and disadvantages.

Pros and cons of the Wyckoff pattern

The method's strengths include comprehensive analysis, effective risk control, objective market signals, and the study of price in conjunction with trading volume. Wyckoff also developed a new type of chart, the dot-dot chart, which allows you to predict target price levels (i.e., how much an asset will rise or fall).

Applying this method in the Forex market has several advantages:

• Analysing market cycles. The method allows you to identify the different stages of the development of assets.
• Determining entry and exit points. The Wyckoff pattern helps traders determine the optimal moments for buying and selling.
• Awareness of market trends. It allows you to better understand the movement of money in the market.

However, this method has some disadvantages:

• Not suitable for short-term traders. There are better choices than the Wyckoff method for short-term traders.
• Difficulty of application. The approach requires a deep analysis of multiple market factors: support and resistance levels, the ratio of price and trading volume, as well as the consideration of several alternatives at once.

In general, trading with this method requires a systematic approach and a deep study of the theoretical principles outlined by Wyckoff and his followers.

How to trade the Wyckoff pattern

The method is based on Wyckoff's theories, strategies, and trading rules. Here is a step-by-step approach to using the Wyckoff pattern in Forex:

1. Analyse the current market situation and make a forecast for the future. Evaluate whether the market is moving up or down.
2. Choose an asset that matches the trend direction. Pay attention to assets that show more strength during upswings and less weakness during downswings.
3. Select the asset in the accumulation or distribution phase (if you are selling). Such an asset may increase in value and reach or even exceed your target price.
4. Assess the asset's readiness to move. Study its price, volume, and the overall market dynamics. Ensure your choice is justified and you are ready to open a position.
5. Time your trade to take advantage of significant market reversals. If you believe the market will turn around and go up, buy the asset. If your analysis shows that the market will fall, sell the asset.

Final thoughts

• The Wyckoff method is a technical analysis tool that allows investors to determine which assets are worth buying and when.
• The method's essence is the analysis of market cycles, which, according to Wyckoff, determine price movements.
• The cycle consists of four phases: accumulation, markup, distribution, and markdown.
• Wyckoff believed that a price trend never fully repeats, and past price behaviour must be considered when making decisions.
• Applying the Wyckoff theory helps traders make more informed decisions about buying and selling assets based on market cycle analysis.