The Market Cycle and the Four Trades

The Market Cycle and the Four Trades

The early twentieth century was a time of great progress in markets and in thinking about markets. There were giants on the earth in those days—legends like Jesse Livermore, old man J. P. Morgan, Bernard Baruch, and Charles Dow. In this fertile environment, Richard Wyckoff developed his understanding of markets and the trading process through conversations and interviews with these master traders. 

After amassing a sizable personal fortune in the markets, he laid out his system in a set of correspondence courses, as was the practice of the day, to educate the public and to help them avoid the scams and frauds that were so prevalent at the time. 

Referring to the Wyckoff method is a bit of a misnomer, for he offered no simple system or one way to trade. Rather, Wyckoff created a method for understanding the buying and selling convictions of very large traders and institutions through the patterns their activity left on prices. 

If the smaller trader could recognize the signs they left in the market, he could align his positions with their activity and interests; in the end, it is the buying and selling pressure of these large pools of money that actually moves the markets. 

This method is as powerful and as relevant today as it was a hundred years ago. Wyckoff proposed a four-stage market cycle. His idea was that the cycle resulted from the actions of these large players who planned their operations in the market to take advantage of the uneducated public’s inappropriate reactions to price movement, but we also see evidence of this cycle in the price patterns of assets such as medieval commodity prices; stocks in early, unsophisticated markets; or trading on very short time frames. 

It is unlikely that there is the same intervention and manipulation in all of these cases, so the Wyckoff cycle may simply be an expression of the normal ways in which human psychology expresses itself in the marketplace.

WYCKOFF’S MARKET CYCLE

In this brief introduction, we will consider three aspects of each phase of the cycle. First, we will try to understand the market using a simplified model focusing on the psychological perspective of two major groups: the smart money players who are assumed to be driving the market, and the general, uninformed public. 

Second, we will consider the crowd psychology of the public, and how individuals are naturally inclined to make mistakes that work in favor of the smart money. Last, we will begin to consider the distinctions and patterns of each part of the cycle from a pure price-pattern perspective; this analysis is important because it motivates and provides context for many trading patterns and methods. 

Figure 2.1 presents this cycle in a simple, idealized format. The four phases are: 

1. Accumulation: A sideways range in which large players buy carefully and skillfully, without moving the price. The public is unaware of what is going on; the market is off the radar and out of the public focus while under accumulation. 
2. Markup: The classic uptrend. At this point, the public becomes aware of the price movement, and their buying serves to propel prices higher. Smart money players who bought in the accumulation phase may sell some of their holdings into the strength of the uptrend, or they may just hold and wait for higher prices. 
3. Distribution: Eventually, the uptrend ends and the market enters a distribution phase in which the smart money players sell the remainder of their holdings to the public who are still generally anticipating higher prices. Really smart money players might even sell more than they own and go short in this range. 
4. Markdown: The downtrend that follows distribution. Smart money players who are short will buy back some of their shorts into this weakness. Eventually, the public realizes that higher prices are not in their future, so they panic and sell their positions. This panic, more often than not, marks the end of the downtrend.

Accumulation—Building a Base 

Accumulation is the first stage of the cycle; large operators (funds, banks, other institutions, or even large individual traders) buy without alerting the public to their intentions. This is actually very difficult to do, as buying pressure will naturally support and even raise prices. 

These players must buy slowly and generally passively over a long period of time to build their positions. From a technical perspective, prices move sideways in a trading range bounded by rough areas of support and resistance, an intermediate-term moving average is flat, and price chops back and forth on both sides of that moving average. 

As we mentioned earlier, these conditions are indicative of a market in equilibrium, and most technical traders should avoid trading price action like this. However, Wyckoff argues that this is precisely the goal of the longer-term players. 

They are working very hard to make this look like a market in equilibrium, but it is not. There is a subtle imbalance as smart money is buying and accumulating positions in preparation for the coming uptrend. 

There are a few important points to keep in mind about a market in accumulation. First, there is the obvious play of positioning in the accumulation area with the smart money; in most cases this is essentially a higher time frame play. 

The line between trading and investing can become somewhat blurred if the technical trader plays in these areas, but the key difference is that traders remain alert for signs that the accumulation has failed.

If contradictory price action and market structure emerge, they will exit their positions, while investors will usually wait for lagging fundamentals to signify that something has changed. This leads to the second point, which is that accumulation areas are usually not simple plays in actual practice. 

It is difficult to time the precise beginning and end of these areas, and the limits of the range are often not cleanly defined. Traders paying breakouts above the range, or stopping out of their positions below the range, will often find themselves executing at exactly the wrong points as they react to price spikes in the noisy range. 

This is what the market action is designed to do in these areas, so do not play this game. There are some price patterns and clues we typically see associated with classic accumulation. The most common of these is what Wyckoff called a spring, which is called a failure test at the bottom of the range in modern terminology. 

To understand this pattern, think of it from the perspective of the large players accumulating inventory in the range. If these large buyers were to go into the market and buy aggressively, that buying pressure would be a significant portion of the market activity. 

The market would almost certainly explode higher, which is not what the large players want at this point. It is critical that they measure their buying activity over a long period of time so that they do not lift prices; it is a game of deception. 

If these large players discover that they can consistently get filled near the bottom of the range (where the market is cheapest), they might buy even more slowly to see if the prices would decline even further. Low prices are good for these players, who are trying to accumulate large positions at the lowest possible price. 

What if they wanted to judge the other market participants’ interest in the stock? Perhaps they might stop buying altogether and let the market fall under its own weight.

From this point, there are two different scenarios that they would be watching for. In one, the market drops and keeps dropping, and they see that the rest of the market really has no conviction or interest. Depending on their plan for the campaign, this might or might not affect their decision to continue buying.

Perhaps they are very happy to buy the market even lower, or perhaps it is weaker than they expected and they might have to slowly unwind their positions. Large players like these do not take significant losses very often, but they are also not always right. 

The other possibility is that they stop buying and the market falls, but other buyers immediately step in and arrest the decline. In this case, the large players just got an important piece of information: there is underlying buying interest in the market. 

Keep in mind that these types of buyers, and so this type of price action, tend to be very large and very slow moving. These are usually institutions that may buy many times the stock’s average daily trading volume, so most of these plays develop on an almost glacial scale; but, even so, there are critical inflection points that can be defined in minutes or seconds. 

These drops below the bottom of the accumulation range are examples of specific points in time that require attention and focus. The presence of other buyers just under the level where the institutions were buying telegraphs real interest. 

The large player would probably be compelled to immediately resume their buying plan, working very hard to not spook the market. Again, it is a game of deception. If enough players sense the buying pressure, the market will explode into an uptrend, and the large players do not want this until they have accumulated their full line. 

This type of activity leaves a distinctive and important pattern on a price chart: it will be clear that the market has defined a support area and that price has probed below that support, but that the market spent very little time there because buyers immediately stepped in and pressed the market higher. 

This is one pattern that candlestick charts can highlight well. Candles with long shadows extending below support but with few or no closes below that support are a sign of accumulation. If we were to look inside the candles on a lower time frame, 

we would see that most of those excursions below support lasted less than a quarter of the time frame of each candle (i.e., a daily chart spends at most a few hours below support, an hourly chart less than 15 minutes, etc.). Figure 2.2 shows an accumulation area in daily October 2010 Platinum futures. 

The dotted line is not an exact level, but notice that only candle shadows touch the area—the market is unable to close near the level. Also, the bar marked A is a classic Wyckoff spring, which is a bar that tests below a level and immediately finds buyers. 

In this case, the price movement off this day led to a multimonth rally. This is an important lesson about putting chart patterns in context. A simple statistical test of candles with long lower shadows would find that there is no predictive power to that pattern, but when a market is potentially in accumulation, the presence of these springs can distinctly tilt the probabilities in favor of the upside. 

Everything we do as traders is a matter of shifting probabilities. We deal in probabilities, not certainties, but the position and context of the higher time frame can often provide warning that a market could be under accumulation, lending more importance to these lower time frame patterns. 

Notice also that this is a subtle pattern. Though these are not exciting patterns, they are important and contribute to a trader’s overall read on the market’s action. It is

also worth considering that what I am presenting here is an idealized and simplified perspective on a market in accumulation. In actual practice, these patterns are often much more complex and obscured by noise. 

From a longer-term perspective, crowd psychology is simple and easy to understand while a market is in accumulation. If the smart money operators are accumulating well and doing their job right, the public simply does not care about the market. 

The distinguishing psychological feature of a market in accumulation is that it is off the public’s radar; no one is thinking about it or talking about it. No journalist writes an article about a market in sideways consolidation, and no one talks about such markets on television. 

They are invisible and boring; only smart, professional traders know to watch for these formations. At some point, unobserved and unnoticed, the accumulation breaks to the upside and the stock moves into the next phase of the cycle.

Markup: The Classic Uptrend

The second part of the cycle is the uptrend (markup), and the action of the smart money is not as clearly defined here. Perhaps the institutions may simply hold their full line until the stock is marked up to prices at which they consider it advantageous to sell, or perhaps they will actively buy and sell with the fluctuations of the trend. 

The public psychology in an uptrend is a subject for study in and of itself. Usually, trends begin out of accumulation and there is little attention from the public. Trends begin in sneaky, unnoticed ways, but, at some point, the price advances far enough that people start to take notice. The classic first reaction is disbelief, followed by a desire to fade (go against) the move.

If Wheat futures have been locked in a $1.00 range for a couple of years, most people are apt to regard a price $0.50 above that range as too high and will be inclined to short, thinking the aberration will correct itself. 

This price movement will still not be in focus in the major media, but, when people do talk about it, they will almost universally observe that “fundamentals do not support this move” and there are also many narrative factors that suggest “the risk is too high to consider buying up here.” At the beginning of trends, the prevailing mind-set from the public is usually that the trend is somehow wrong. 

As the trend grinds higher, the early, aggressive shorts will be forced to cover, and their buying pressure will, in turn, push the market higher. (Here is a clear example where short sellers are actually a source of significant buying pressure; things are never as simple as they seem, and regulatory pressures to curb short selling are naive and misdirected at best.) 

The public’s initial disbelief slowly turns into acceptance, and people start buying every dip in an attempt to position themselves with the trend that is now obvious and fully underway. If the trend continues, there may be news stories in the major media featuring the trend, but talking heads will still be divided on the subject. 

Some will have switched their bearish bias, observing that the market is simply going up, perhaps “climbing the wall of worry” put up by other commentators who still insist the movement cannot be justified by the fundamentals. 

If you are positioned long in such a trend, this is good—the division of opinion is fuel for the fire. You want dissenting opinions at this point in the market cycle. We will spend an entire chapter refining our understanding of the characteristic features of price action in trends, but the basic pattern is a series of with-trend legs interspersed with pullbacks, which are also called retracements. 

Trend traders usually focus a lot of attention on the relationship of each trend leg and pullback to previous legs, in terms of magnitude, length (time), and character (primarily referring to lower time frame price action). 

Trading plans in trends usually involve either buying into the pullbacks or buying breakouts to new highs as the trend continues higher. Though there have been many attempts, no one has found a reliable way to judge the large-scale psychology of market participants; however, an understanding of the emotional cycle that drives trend moves is very important. 

Because market action is, at least to some degree, the sum of many traders’ and investors’ hopes and fears, many people observe that price action often encourages traders to make mistakes. Markets often present us with the temptation to do the wrong thing at the wrong time, and we will be lured into doing so if we do not understand the psychology of the crowd. 

Understand this so that you can stand apart from it. The emotional cycle of trends can be summarized as disbelief, acceptance, and, eventually, consensus. When everyone agrees, the trend is usually close to being over.

In some trends, mania sets in and things get a little crazy. Now, everyone will be talking about the movement. All the pundits will be in agreement. Even though the market may have appreciated several hundred percent in a year’s time, it is now obvious to everyone that there is real demand and the situation is only going to get worse. 

There will be dire calls of shortages and claims that increased global demand cannot possibly be met by supply. Common sense goes out the window and people do not recognize the significance of the most basic fundamental factors, or, more accurately, 

they do not understand how fundamental factors change. For instance, in the case of an agricultural commodity, there will be news stories about how the world is running out of the commodity, probably a story here and there about some blight that will destroy the crop on one continent or another, and what are basically calls for the end of the world. 

For some reason, no one will notice that farmers just planted three times the acreage that was planted in the previous year—the invisible hand is funny like that. Though the manic uptrend seems like an unstoppable force, something very interesting is about to happen: this unstoppable force is about to meet the immovable object in the form of massive supply coming online. 

Here is an important lesson for the objective trader: your clue to the fact that psychology has reached the mania stage is when stories begin to show up in the popular, nonfinancial media. 

At times like that you have one job and one job only—detach yourself from the mass psychology and begin to exit the market. At the very least, you must book partial profits and take steps to reduce the risk on your remaining line. 

Distribution—The End? 

Nothing goes on forever. At some point, higher prices will bring increased supply into the market, balance is achieved, and prices will stop rising. From a technical perspective, there are, broadly speaking, two ways this can happen. 

The manic blow-off end-of-trend pattern just discussed is unusual, but deserves attention because it presents dramatic opportunities and dangers. More common is that the uptrend just runs out of steam, and the market goes into another sideways trading range. 

The large operators who accumulated positions in the first stage and who held most of their line through the markup now begin quietly selling their inventory to the public (distribution). In the accumulation phase, it was important that they hide their buying so as to not cause the market to break into an uptrend too early. 

Similarly, they must now sell carefully because too much selling pressure could crack the market into a downtrend. To the untrained eye, distribution areas are indistinguishable from accumulation areas—they are both large, sideways ranges. However, on a more subtle level, we will see that many of the classic signs of accumulation will not be present. 

When prices drop below support, the market will not rebid quite as quickly. In general, prices may spend more time hugging the bottom of the range; pressure against the top of the range is a bit more common in accumulation. There may even be false breakouts of the top of the range, leaving the candles with long shadows above the highs of the range. 

This pattern is the opposite of the Wyckoff spring, and is usually called an upthrust. Eventually, prices will drop below support at the bottom of the range and will fail to bounce. The market will roll over into the last phase, markdown. 

Psychologically, the public is usually still hopeful when a market goes into distribution. They will seize every potential breakout as proof that a new uptrend is just around the corner, and will usually look for any excuse to keep buying. 

Keep in mind that this pattern occurs in markets that have just had substantial advances, so it is easy to say things like “Look, this thing is up 50 percent year over year, the fundamentals are great, and the Street obviously loves it.” Every dip is an opportunity to pick up additional shares or contracts, which are now cheaper, so they are basically on sale. 

Who could pass up such a great opportunity? The public, however, is blind to the subtle differences in patterns that hint that another trend leg up might not be in the cards. Trading real markets is not quite this simple.

For one thing, markets in second phase uptrends will frequently enter fairly extended sideways ranges in the middle of the trend. Should these be treated as further accumulation areas, in preparation for another markup, or is the trend over and these are distribution areas? 

There are subtle clues in market structure and price action, but it is not always possible to make an accurate judgment in real time. Looking back, or at the middle of a chart, the answer is obvious, but it will not be so obvious at the hard right edge. 

Even with the best analysis and trading plan, we will simply make the wrong decision sometimes, so any good trading plan will focus on risk management first. 

Markdown: The Bear Market 

The last stage is markdown, which, in many ways, is the inverse of the markup. Psychologically, if the market has been in a protracted distribution phase, the public will most likely have lost some interest. Some traders will be optimistic, and will plan to “get back in” whenever it moves, but, in general, the public focuses on the same things the major media do: hot markets that are moving. 

These traders will easily be able to justify buying new highs above the distribution area, as this is how another trend leg would begin. They also will be able to justify buying breakdowns below the distribution area, because the market would be cheaper (on sale?) at those levels. 

The level of interest will probably be relatively low because the public usually focuses on markets that move, but the general tone will likely be very positive. 

After all, everyone is now in agreement that the market is going higher, right? Real downtrends begin out of this environment of optimism or complacency. Eventually, it becomes clear that the declines are a little steeper than expected, and some longs begin to unwind their positions, adding to the selling pressure. 

The mood of the market changes from optimism to disappointment, and aggressive shorts may even begin to show some teeth as they make larger profits on each successive decline. Bounces fall short of previous highs, and people begin to sell even more aggressively. 

At some point, everyone becomes convinced that the company is going out of business or that commodity is “done” or the currency will never rally, and that the correct play is to short it into oblivion. 

As you might expect by now, such an emotional extreme more often than not marks the very bottom, and the market stabilizes into accumulation in preparation for the next uptrend. Market structure and price action in a downtrend are not a perfect mirror image of the first stage, but the differences are subtle and difficult to quantify. 

One of the major pieces of received wisdom from old-school traders is that markets tend to go down much faster than they go up. There is some truth to this, as volatility reliably expands on declines in many markets, and there is also a subjective side to the analysis, as there is a distinctly different feel to rallies in a bear market compared to sell-offs in a bull market. 

Both structures are pullbacks in established trends, but there is a special kind of franticness and volatility that seems to be a unique attribute of bear markets. Bear market rallies tend to be sharp and vicious, whereas pullbacks in bull markets are usually much more orderly. 

There is a surprising degree of symmetry—most elements of uptrends and downtrends are mirror images of each other (reflected around the y-axis), but most traders also find that a very different skill set is required to trade each environment. This may explain why some traders avoid bear markets whereas others specialize in them. 

The Cycle in Action

The structure laid out here was originally conceived around the equity markets and on time frames ranging from months to years. 

It applies especially well there, but it also has relevance to other markets and shorter time frames. Commodity markets tend to follow a similar cycle, but the cycle in commodities is often driven by the production and consumption cycle. 

Commodities, in general, tend to be a little more cyclical and more prone to seasonal distortions, especially of volatility, than stock indexes are.

Currency markets tend to be a little less cyclical and tend to trend better than most other asset classes over longer time frames. That said, there certainly are times when this cycle does apply to the currency markets—for instance, in extreme situations accompanied by emotional elation or stress. 

The concept of fractal markets, as Mandelbrot and Hudson (2006) have written about, is especially important when considering the Wyckoff cycle. Simply put, this means that the same patterns appear in very long-term markets as in very short-term markets. 

However, much of the academic work supporting this concept does not recognize that patterns may not be tradable on all time frames. It is not always possible to trade 5-minute charts the same way as weekly charts, even though the patterns may superficially appear to be similar. 

In addition, not enough work has been done on the relationship of fractal markets and liquidity. In the shorter time frames, patterns are bounded by liquidity. For instance, very active stocks might show fractal patterns down to the 15- second time frame, while less liquid commodities or stocks might degenerate into noise anywhere below the daily level.

So, it should be easy to make money trading this cycle, right? Find accumulation on your chosen time frame. Buy. Wait for distribution. Sell and sell short. Cover shorts when the market goes back into accumulation. 

Repeat. Simple, right? Not so fast. Though this cycle provides a useful road map and large-scale framework, there are many nontrivial problems in actual application: 

•  Accumulation does lead to significant advances, but it is difficult to time entries out of accumulation areas. Buying breakouts results in a string of small (or, depending on your trade management discipline, not so small) losses that do add up. 
• Buying within the accumulation area is not simple, as there are usually no clear risk points. Setting stops under accumulation areas is usually wrong, because you want to be buying those flushes, not selling into them. 
• Sometimes what looks like accumulation turns out to not be accumulation, the bottom drops, and the market does not look back. Small losses can quickly become big problems in this environment. 
• Trading bull and bear trends (markup and markdown) is also not as simple as might be expected. There are many tradable patterns in trends, as well as patterns that suggest the trend is coming to an end, but it takes real skill to identify and to trade these patterns. 
• Markup periods often go into long, sideways ranges that may be either accumulation or distribution. The pattern is not always accumulation → uptrend → distribution; it is sometimes accumulation → uptrend → accumulation, or some other variation. 

And perhaps most importantly, remember that no trader is correct 100 percent of the time, and being wrong means being on the wrong side of the market. Risk management is essential to limit the damage on the times you are wrong.

THE FOUR TRADES 

Wyckoff’s market cycle is a highly idealized view of market action, but it does lay the foundation for a simple categorization of technical trades into four categories. There are two trend trades: trend continuation and trend termination, and two support and resistance trades: holding and failing. 

Though this may seem like an arbitrary classification system, it is not. Every technical trade imaginable falls into one of these categories. 

Trades from certain categories are more appropriate at certain points in the market structure, so it is worthwhile to carefully consider your trades in this context. The first question to consider is: Are all of your trade setups in one category? If so, this may not be a bad thing—a successful trading methodology must fit the trader’s personality—but most traders will have the best results when they have at least two counterbalancing setups. 

For instance, a trader who focuses on breakout trades should probably understand the patterns of failed breakouts. A trader who trades pullbacks in trends should probably also be able to trade the patterns that occur at the ends of trends. 

There are two reasons behind this suggestion. First, you should become intimately familiar with the patterns associated with the failure of the patterns you trade. The second reason is related to self-control and psychology—there is an old saying: “If the only tool you have is a hammer, every problem you encounter will look like a nail.” 

If you are only a skilled breakout trader, you may find it difficult to wait for the excellent breakout trades, and may try to force suboptimal patterns into this mold. If you have the freedom and the skills to switch to the setups that match the market conditions, you will be a able to adapt your trading skills to the market environment. 

There is certainly room for the specialist who does one trade and does it very well, but many traders find success with a broader approach. Some market environments favor certain kinds of plays over others. 

If you are a trader who trades all categories, are you applying the right kind of plays to the right market environments? For instance, do you find yourself having many losing trades trying to short against resistance levels in uptrends because you feel they have gone too far?

If so, your results might improve if you apply with-trend trades to those situations and more carefully define the market environments that will reward your fading (going against the trend) of strength into resistance. 

Those environments exist—you just aren’t finding them with your plays. If you are a specialist who focuses on only one setup or pattern (and, to be clear, this is not a criticism if you are successful this way), then you need to realize that only a few specific market environments favor your play and wait for those environments. 

You can redefine your job description to include not trading. Wait on the sidelines, and wait for the environments in which you can excel. Again, those environments exist, but you probably are burning through a lot of mental and financial capital trying to find them. 

Clarify your setups. Categorize them, and then simplify, simplify, simplify. Let’s look briefly at each of the four broad categories and ask the following questions from a general, high-level perspective: 

• Which trade setups fall into this category? 
• What are the associated probabilities, reward/risk profiles, and overall expectancies of these trades? 
• How do these trades fail?