Wyckoff's Laws and Smart Money
"Technical Analysis of Stocks & Commodities" in the October 2002 issue name Richard D. Wyckoff one of the five Titans of Technical Analysis? From the man who didn't think much of chartist to the premier chart reader of our time. There are purists who run forums dedicated to his approach to those who have adapted his methods (VSA and WCVA) and created dozens of indicators based on his methods. Though he died in 1934, the course he wrote in 1931 is still being sold ($1k) today.
What I am attempting to do here is present Wyckoff's three laws in a way that readily exposes the "Smart Money" rationale behind them. Wyckoff carefully studied the "Smart Money" traders of the time and discovered that all markets are moved by the big players he called the Composite Operator (CO). Of course there are many deep pocket traders who make up the CO, but it is much easier to consider them all as a single entity*. Amoung these traders are Market Makers, Specialists, and , with the ever advancing computer systems, Dark Pools. Basically they all work the same way. I'll use the Market Maker (MM) to illustrate their manouvers.
A MM may have an order to buy 10 million shares of a stock. He will not simply put a 10,000,000 share order in at a price. That order would be liable to drive the price higher. Instead he will put a 50,000 stock order in at $50 a share, which is the current bid and wait. As the 50K order is filled he will put in a new order at $50 and so on to fill his big order.
Via his computer system, he will try and hide the fact that there is a buyer at $50 a share by varying the price, timing and size of the broken up order. This disguises what is going on. In his capacity, the MM has the best knowledge of what the overall supply/demand conditions are - privileged information that is used to accumulate long or short positions based on supply and demand in the marketplace.
This falls under the function of providing depth and liquidity in times of supply/demand imbalance. This allows the MM to buy on the bid, and sell on the offer, and profit from the spread.
Wyckoff's Three Laws:
1. The Law of Supply and Demand - states that when demand is greater than supply, prices will rise, and when supply is greater than demand, prices will fall. Here the analyst studies the relationship between supply vs. demand using price and volume over time.
The price of every equity moves up or down because there is an excess of demand over supply or supply over demand. Redmont gives a simple example:
"You are looking at a stock. It trades 10,000 shares and goes up one point on the first day. The same thing happens on the second day. On the third day, it trades 20,000 shares and goes up 1 point. On the fourth day, it trades 40,000 shares and goes up half a point. On the fifth day, it trades 80,000 shares and is unchanged."
"On the third day, you had to exert twice as much effort to get the same result (as the first day)," Redmont noted. "The key to analyzing supply and demand is that the demand side burns itself out."
"When the buying is through and satisfied-there is always supply there. That's why prices go down faster-because supply is always there and demand is not. All you have to do is withdraw people who want to buy and prices fall."
2. The Law of Effort vs. Results - divergencies and disharmonies between volume and price often presage a change in the direction of the price trend.
Again: the Law of Effort (volume) versus Result (price) in action.
The law of effort vs. result states that the change in price [spread] of a trading vehicle is the result of an effort expressed by the level of volume and that harmony between effort and result promotes further price movement while lack of harmony promotes a change in direction.
3. The Law of Cause and Effect - postulates that in order to have an effect on you must first have a cause, and that effect will be in proportion to the cause. This law's operation can be seen working as the force of accumulation or distribution within a trading range that works itself out in the subsequent move out of that trading range.
The idea is to measure this cause and project the extent of its effect. The excesses that develop in supply and demand are not random but are the result of key events in market action or the result of periods [candles] of preparation. Wyckoff teaches what these developments are and how to judge when they are unfolding in time to take advantage of the excesses in supply or demand that will follow.
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