One of Wyckoff’s major contributions is his Market Cycle: an algorithm of the interrelationship between price changes, market phases, and institutional money flows. In the Accumulation phase activist hedge fund managers, value investors and proprietary trading desks accumulate a position in a stock. In the Markup phase trend-followers emerge, hedge funds trade on catalysts or rapidly moving stocks, and speculative bubbles begin to form. The Distribution phase is where the remaining institutional trading desks sell to retail investors, and rational herding in range-bound markets occur. The Markdown phase involves crashes, panics, short-selling, and distressed debt.
Wyckoff’s Market Cycle was an attempt prior to market microstructure theories to explain phase shifts in financial market dynamics.
This week I read the first couple of chapters from Laszlo Birinyi‘s book The Master Trader: Birinyi’s Secrets to Understanding the Market (Hoboken, NJ: John Wiley & Sons, 2013). Birinyi’s first three chapters use event and observation studies to debunk a naive use of Edwards & Magee-style indicators for market sentiment. In the fifth chapter Birinyi introduces his Money Flow analysis on block trades, and flows in and out of a stock. For Birinyi, the Money Flow indicates market circumstances where there will likely be high-probability shifts in stocks. He also acknowledges that dark pools, high frequency trading, and other recent market innovations now affect the reliability and construct validity of Money Flow analysis as a predictive tool.
In that moment I made an abductive inference: what if traders combined Birinyi and Wyckoff? Birinyi’s Money Flow analysis shows that money flows into stocks from hedge funds and proprietary trading desks during the Accumulation and the early Markup phase; and to trend-followers and retail investors during the Markup phase. Money flows between these different traders during the Distribution phase. Money flows out from the majority of investors during the Markdown phase to short-sellers and distressed debt / value investors.
There are a couple of ways to build a combined Birinyi-Wyckoff trading system:
- Write out the Birinyi and Wyckoff models as a series of If-Then-Else-ElseIf nested loops or develop an expert system.
- Use Case Based Reasoning on historical examples such as Markup manias and Markdown phase panics and crashes.
- Do market microstructure analysis of the order book, volume, and order flow.
- Use complex event processing and stream processing to develop a real-time system using market data, Bayesian belief nets, and machine learning.
These options for capability development are part of what a post-PhD project on the sociology of finance might explore.