The Wyckoff Wave: Relative Strength and the Optimism – Pessimism Index

Click Here For Wyckoff Wave Chart 11-18-11

One of the most important Wyckoff techniques is breaking down an index’s or stock’s daily action into individual up waves and down waves. This allows us to determine how much of the day’s volume is demand and how much is supply. This information is then transferred to the Optimism – Pessimism Index (O – P).

The O – P is a continuing number. Each time there is an up wave, the wave’s volume is added to its O – P. Conversely, volume is subtracted after a down wave. The actual number portrayed in the Optimism – Pessimism Index isn’t important. The significance is when the relative numbers are compared with the highs and lows from the vertical line charts.

The Optimism – Pessimism Index represents effort. The prices on the vertical line chart represent results. The trick is to compare the O – P’s effort and the vertical line chart’s results with previous highs and lows. If they are not in harmony, these negative divergences can help identify possible turning points.

The O – P can often lead the index or stock price during longer-term advances. There is a tendency for the effort shown by the O – P to pull the stock along with it as it advances. This action should not be confused with a negative divergence which can suggest a possible turning point.

When the Optimism – Pessimism Index is unable to keep pace with its vertical line chart partner, we should pay close attention and look for a possible change in direction. A classic example of this is on the attached weekly chart of the Wyckoff Wave.

After the bear market of 2008, the Wyckoff Wave began a long advance to the highs of 2011. The long-term uptrend channel is drawn on the weekly chart. At point E, the Wyckoff Wave moved into an overbought position relative to the uptrend. Note the level of its Optimism – Pessimism Index. It is 61,963.

The Wave then reacted to point F and rallied to a new high at point G. However, for the first time, the O – P did not keep up with the Wyckoff Wave. At point G the O – P Index was only 61,921. The effort was not matching results. This negative divergence suggests that even though the Wyckoff Wave appears strong, trouble lies ahead.

Trouble appeared in lower tops at points S and U. In addition the negative divergences continued. The O-P at point S was 61,980 compared with the 61,921 at point G . Then we saw huge reaction, in a short period of time, to point X. This was the “bear market” of 2011. While the decline did not begin until August, the Optimism – Pessimism Index gave us an early warning signal in late April.

The reaction ended in early August with a Selling Climax at point X. Notice point X on the
O – P Index chart. The Wyckoff Wave rallied to point Y and then reacted to point Z. Point Z held above point X. If we look at the O – P chart, notice that at point Z the O – P has gone into new low ground. This is a positive divergence and the Wyckoff Wave rallied. Again, the Optimism – Pessimism Index gave us a signal that the market was turning upward.

An even more important signal came when the Wyckoff Wave sprung the trading range at point H. The Wave moved into new low ground, but the Optimism – Pessimism Index was substantially higher. In fact it was consistently showing higher tops and higher bottoms. Another fantastic negative divergence and the Wyckoff Wave rallied strongly to point K. This certainly could be called a major Sign of Strength (SOS). Now, we just had to wait for a nice back up to the Creek for a major Last Point of Support (LPS) and we were off to the races.

However, good supply came into the market as the Wyckoff Wave reacted off point K. There was a weak rally to point M. Point M held below point K. But look at the O – P chart. We had another negative divergence as the O – P moved higher than at point K and the Wyckoff Wave did not. The same thing happened on the rally from point N to point O.

These negative divergences with the Optimism – Pessimism Index suggested this would not be a traditional backup. While there was still a chance for the Wyckoff Wave to continue to absorb supply, time was certainly growing short. The tremendous effort being put in by the O – P Index was not being matched by the Wyckoff Wave.

As we have seen in recent days, supply has overcome the demand and the negative indications presented by the Optimism – Pessimism Index are coming to fruition.

Now it will be important to watch the O – P Index as the Wyckoff Wave reacts back into the trading range. The O – P Index has been stronger than the Wyckoff Wave since the trading range began back in August. It will be interesting to see how it compares with the Wyckoff Wave as it tests point J and possibly the bottom of the trading range.

I have found from experience that while the Optimism – Pessimism Index is not a mechanical timing tool for short-term traders, it is excellent in predicting market turns. It is an extremely important tool for the Wyckoff trader.

As it appears that the Wyckoff Wave will not put in a Last Point of Support and will return to the trading range, what lies ahead? Are we seeing the beginning of a new bear market, or will the Wyckoff Wave simply return to the trading range and begin a third phase. Phase 1 is from point X to point H and phase 2 is from point K to point O. While the jury is still out, the trading range scenario appears to be the most probable option. The relative strength of the O – P Index can well create some positive divergences on the reaction and an oversold Technometer should slow down or stop a steep decline.

The short term trend of the market is still down.
The intermediate term trend of the market remains neutral.