What Happened to the Test of the Spring (Shakeout)?

Click Here For Wyckoff Wave Chart 04-27-12

In my last market letter, I discussed how the Wyckoff Wave would be testing the spring (shakeout) we saw at point F. While we did see a brief reaction on Monday to point H, the day’s market action was not of good quality and the Wyckoff Wave rallied for the next four days.

Patently, this past week did not bring a test of the spring, but it did present an opportunity to discuss some important Wyckoff principles.

The Wyckoff Wave is aptly named as the stock market’s highs and lows are like the crests and troughs of ocean waves. They begin quietly and grow to be quite significant. Whether you are short-term trader looking at intra-day waves or an intermediate term trader who studies the most significant waves, the lessons are still the same.

It is important to understand that it takes a multitude of smaller waves to develop the significant ones. The Wyckoff Wave’s action from the spring gives us an opportunity to look at this in more detail.

As discussed previously, the Wyckoff Wave sprung the market at point F and rallied nicely to point G. There, the rally appeared to run into trouble and we saw a sharp decline (marked by the red arrow), a poor quality rally and another decline to point H.

The day marked by point H was interesting in that there was a large gap opening to the down side. The Wyckoff Wave then spent the rest of the day rallying and closed at the top of its price spread. Despite the fact that today’s close was substantially lower, one can see by the chart that good demand came into the Wyckoff Wave. This was inconsistent with the expected reaction to test the spring and was a warning sign that the test may be in a bit of trouble.

It was also important to look at the volume of the Wyckoff Wave beginning with the day marked by the red arrow. Notice the high-value. That was normal as we were expecting a reaction to test the spring. It would’ve been nice to see some good follow-through to the down side and some reduced spread and volume, which would indicate we may have a successful test. That didn’t happen

The next day the Wyckoff Wave rallied on decreased spread and decreased, but relatively high volume. While the volume was decreasing, it was still high compared to previous reactions. This relatively high volume was sending us a message. It was either we have good supply and the reaction will continue or, there is a bit more demand than expected. A reaction to test a spring is to allow supply to dry up. A successful test means that demand comes into the market only when shares are scarce. On a successful test, demand is not fighting with supply because there is little supply left to do battle.

This is important, because we expect to see this drying up of supply on a test of the spring. If we don’t, there is a change in character and things are not going to go exactly as expected.

This is why the day marked by point H is so significant. Demand should not be coming into the market at point H because supply is not dried up. This would suggest demand is coming in for another reason. It turns out, the reason was the rally off the spring had been completed. Apparently we were either going to test the highs at point G or the rally from point H was simply a continuation of the rally off the spring. Whatever the reason, we were not yet in a reaction to test the spring.

The day following point H brought increased price spread and decreased volume. The relative volume was still high, suggesting some demand was still present. However, the day’s price spread and volume did suggest a lack of supply. This was interesting as it is not uncommon to see a lack of supply at the beginning of a rally.

Does this mean that point H was indeed the test of the spring? Could we say that the decreased spread and volume compared to the day marked by the red arrow would justify a test?

The answer is absolutely not. This is where we have to be disciplined. Basic Wyckoff tells us that a spring is tested on a drying up of supply indicated by decreased spread and volume. The price spread at point H was wider than the previous day and the volume, while reduced, was relatively high.

If anyone needed more convincing, the Technometer was in an overbought condition. I don’t know about you, but I am very skeptical about taking a long position when the Technometer is overbought.

While I was looking for, and expected, a reaction to test the spring, it was very evident something wasn’t quite kosher. When that happens, it is best to move to the sidelines and wait for the market to tell you what it is doing.

On Wednesday (two days after point H), the Wyckoff Wave again rallied. This time it was on decreased spread and volume. This suggested a lack of demand. However, the Wyckoff Wave penetrated and therefore weakened the short term down trend supply line drawn through points E and G. It also took out the highs at point G.

The next day (the second to last day on this chart), the Wyckoff Wave traded higher, again on decreased volume. The price spread and volume suggested a lack of supply. The Wave also substantially weakened the E – G supply line.

This gives us an opportunity to draw in a new, temporary, short-term uptrend channel. This channel, which is drawn in blue may come into play if the Wyckoff Wave continues to rally. However, this does not mean the trend has changed. The short term trend is still neutral. This is because supply line E – G has only been weakened. It has not been broken. It is there primarily to watch how the Wyckoff Wave behaves in the area of the supply line (drawn from point G). This is not a Wyckoff principle. I like to draw in trend channels, whenever possible, simply to watch how stocks behave as they approach either supply lines or support lines. I only believe the trend changes when a trendline is weakened, then tested and resumes its rally or reaction.

We now have a positive wave from points F to G. A negative wave from points G to H. Finally, this past week has been a positive wave. If we compare the strength of the two positive ways, F to G and H to the end of the chart, we see that the second wave is weaker than the first wave.

In addition, the Technometer is dangerously overbought. We are seeing a lack of demand and reducing relative volume. If you notice, the relative volume for the last two days on the chart is below the average volume we have seen since point A.

It is also important to note that the Technometer has been overbought for the last three sessions on the chart. An overbought Technometer is not a mechanical signal that the Wyckoff Wave will react. It is an important tool that needs to be considered, but always is secondary to price spread and volume analysis.

What we did see on Friday is reduced price spread and reduced volume. In addition, supply came in late in the day resulting in a poor close. If you compare this price spread and volume action with the price spread and volume action around point G, you will see the latter is substantially weaker. This, coupled with the oversold condition on the Technometer, suggests we may actually be seeing the beginning of the reaction to test the spring.

It is also an opportunity for intra-day or swing short-term traders to look for positions to the down side.

This whole discussion, while perhaps interesting to intermediate and long-term traders, is irrelevant as they are waiting for a successful test of the spring before entering the market or adding to their positions to the long side.

However, for all Wyckoff students it is an interesting analysis of waves and how they play into more important Wyckoff concepts.