The Significance of the Trading Range for Asset Prices

&
Influencing Factors
By Stephen McKay
Published by
Portfolio Research Partners, LLC

Introduction
Ask any investor which two emotional forces drive a market, and he or she will most
likely answer, Fear and Greed. They know this because at some point every investor
has had these two emotions affect his or her investing decisions. Fear and greed work
in tandem as the strongest influencing factors of market-based asset pricing. During
periods of rising prices, the fear of not wanting to be left behind coupled with the greed
of needing to profit from rising prices, causes investors to bid-up asset values. The
compounding effect of the herd instinct joins fear and greed to further stimulate
market prices, often times to excess and sometimes creating asset bubbles.
The purpose of this whitepaper is to rationalize the emotional drivers of market-based
asset prices and to demonstrate how these drivers affect how prices traverse their
trading range(s).
A trading range is defined by the intermediate peaks and valleys formed by prices
during trading sessions. These prices are essentially defined by the attitudes,
perspectives and emotions of all market participants as price discovery occurs in real
time during the trading day.
Once the interactivity of these forces is understood and the resulting effects
quantified, then traders can more effectively increase trading profits while reducing
risks by selecting more favorable entry and exit points.
In the early 1900s, renowned investor and student of the markets Richard Wyckoff
developed sound theories and practices that helped investors understand these
concepts and profit from them. His work is time-tested and continues to be taught to
students at the graduate level at several American universities. Many market
participants continue to use his trading concepts as the underpinning to
understanding asset price movements.

Tulipmania and Other Asset Bubbles

The market adage of fear and greed is so famous that it has even spurred academic
research about investor irrationalities and how the pair work together to cause
investors cognitive and emotional biases. Neuroeconomic studies have shown how
these two alternating emotions work for traders to distort their decision processes.
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Although these studies may seem new to some, they trace their historical roots to the
works of Adam Smith and Jeremy Bentham in the mid-1700s. One can assume that
even the first stock traders who were buying and selling shares under the old
buttonwood tree at the beginnings of the New York Stock Exchange were influenced by
these two emotions.
More recently, during the dot.com bubble and its collapse, economists and historians
have increased their study of market crazes of the past, particularly the most
ludicrous one of all: the 17th-century Dutch flower bubble.
The classic description of Tulipmania appeared in Clarence Mackay's 1841 classic
Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. Mackay
wrote: "In 1634, the rage among the Dutch to possess them [tulips] was so great that
the ordinary industry of the country was neglected, and the population, even to its
lowest dregs, embarked in the tulip trade.
During a matter of only a few months, the normally sane Dutch bourgeoisie got
carried away and bid up prices of tulip bulbs spectacularly in the winter of 1637, only
to see them crash in the spring. One bulb was reportedly sold in February 1637 for
6,700 guilders, "as much as a house on Amsterdam's smartest canal, including coach
and garden," and many times the 150-guilder average annual income. It was also
recorded that prices at one point reached such a high that twelve acres of land were
offered for one particularly prized variety of tulip bulb.
Modern day cycles have not changed. Investors are eternally optimistic and tend to
have very short memories. When the market is eclipsed by greed during a raging bull
market, fear is forgotten and investors believe that prices will always rise and never
fall. When these market conditions are present, asset bubbles can, and will be
created.

Investors can rationalize any Price Levelfor a While

Part of what causes asset prices to extend into excess and then into a speculative
bubble is the willingness of investors to accept the most ridiculous rationalizations for
the asset pricing during these periods. This is enabled by the greed aspect of the
emotional rationalization.
During the dot.com era, the rationalization was that the Internet was fundamentally
changing business as we knew it. Therefore, companies that had no revenue or even
a proven business model were worth millions or even billions of dollars.
Likewise, when the telecommunications industry was finally deregulated for local
service in the late 1990s, start-up companies were valued based on how much they
invested in network infrastructure or as a multiple of revenue. Investors used any
metric except a multiple of earnings (since there were no companies in this group that
produced positive earnings) to justify nascent valuations even if valuation methodology
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had no basis in financial or common sense. In the end, valuations for these types of
companies imploded and most ended in bankruptcy.
Most recently, the collapse of the mid-2000s real estate bubble was brought on by the
irrational belief by homeowners and lenders that property values would continue to
rise. Market stimulus was further exacerbated by the governments goal of expanded
home ownership, even for buyers who could not afford the debt. This fostered
aggressive lending practices such as drive-by appraisals and/or no documentation
underwriting and which focused on maximizing the size and volume of loan
originations. These factors combined to force residential real estate prices to excessive
levels.
While there are numerous examples of this type of excessive rationalization, from
Tulipmania to the recent real estate bubble, they all have one thing in common: they
all come to an end, and the end is never pretty.
Although the period of rising prices is an incredibly euphoric time with greed firmly in
control, once investor perceptions begin to change and fear sets in, things become very
different, and often this change occurs very quickly.
The same scenario plays out each time. As in the tulip bubble, prices accelerate to a
frenzied level, and then at one point, almost seem to hang in a weightless state for a
short period of time. At this point, the figurative music stops. The once elevated price
level has brought excess supply to the market at a time when demand is now declining
rapidly. Sensing that conditions are changing, the buyers who were in the market to
pay the excessive prices and absorb excess supply have now backed away.
Sellers suddenly find themselves on the wrong side of the supply/demand equation. A
sellers market quickly changes into a buyers market. Buyers retreat further from the
market as prices start to fall. Sellers become fearful and begin to accept prices that
they, only a short time before, would have believed unthinkable. Buyers, sensing a
selling frenzy, have no interest at any price now, as they cannot sense a market
bottom. Sellers are now in a panic because they had built up excess supply during
the markup phase of the speculative price increases and will now have to sell at any
price. Thus, the cycle is being completed with the asset prices entering a furious
markdown phase.
This process works the same time and time again. It is all driven by the same two
primal emotions which caused the initial run-up in prices: fear and greed.

Fear is a Multi-Dimensional Emotion

Its generally easier to understand the motivation of greed: people want to make
money. Fear is a bit more complex, as there are two types of fear: the fear of loss and
also the fear of being left behind. Investors who are able to control both their fear and
their greed have a better chance to come out ahead in the market. As Warren Buffett
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once noted, You know, I always say you should get greedy when others are fearful
and fearful when others are greedy. But thats too much to expect. Of course, you
shouldnt get greedy when others get greedy and fearful when others get fearful. At a
minimum, try to stay away from that.
Warren Buffett deduced before most that understanding human emotion is one of the
most powerful tools used by any investor to analyze the markets current position and
where it is heading next.
He also understood that reacting accordingly is
counterintuitive to our human nature. Buffett recognized that extremes in fear mark
great buying opportunities.
These emotional factors routinely cause asset prices to exceed their nominal levels.
During periods of optimism, prices almost always get bid up beyond their true value
and the same thing happens during a correction when prices are pushed down too far.
This excessive price movement was studied and postulated in the 1930s by Richard
Wyckoff and is depicted in the following graph produced by Wyckoff with his original
work on trading ranges, how they develop and their significance in determining price
momentum and directional change.
The Conceptual Framework of the Effects of Trader Emotions on the Movement of Markets by Richard D. Wyckoff

Based on Wyckoffs work, fear and greed are the principle causes of how asset prices
traverse the trading range and are the direct cause of excessive prices, either high or
low. One can easily deduce from the above graphic how the idealized cycle driven by
fear and greed easily translates into the conceptualized primary market phases. We
will discuss the specifics of each phase of the primary market cycle in more detail
below.

Quantifying the Fear Index

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In 1993, Professor Robert E. Whaley introduced the Volatility Index, or VIX, concept in
a Duke University paper. The VIX is a measure of implied future volatility of the S & P
500 index options. At its core, VIX is a statistical measure of emotions, which cannot
be underscored enough as a major factor signaling capitulation in the market. VIX
measures the level of implied volatility in the market, not historical or statistical
volatility.
The Chicago Board Options Exchange Market began publishing VIX as a numerical
value that same year. VIX measures a 30 day expected movement or volatility of the S
& P 500 index.
VIX can be used as a predictor to divine the future direction of the market as one
compares the movement of the VIX to the movement of the market. Simply stated:
VIX has an inverse directional relationship to the equity market.
Examples of the inverse VIX and Equity Market Index Relationship

During the spring of 2010,

the VIX began to spike and
rose from a level of 16.30 to
almost 48 or a 200% increase
in just 27 trading days. You
can see the effect on the
S&P500 during the same
period in the chart to the left.

During this same time frame,

the S&P 500 Index fell from
1,217 to 1,048 or a decline of
about 14%. It is easy to see
how the sudden fall in prices
caused elevated investor fear
and the selling frenzy to take
hold.
VIX measures our two market drivers, greed and fear.
Implied volatility rises as
investors worry about the future (fear). Implied volatility falls as investors become
more positive about the future (greed). As VIX increases in value, panic may become
an issue. As VIX drops, complacency sets in. Generally, a VIX value greater than 30
is associated with a large amount of volatility, fear, and uncertainty. When VIX values
are less than 20, a less stressful, even complacent, market is at hand. A high VIX
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usually goes hand-in-hand with market bottoms, and a low VIX usually marks the top
of the market.
Because investors are generally long oriented, a rising stock market is considered less
risky to investors, while a declining market is deemed riskier. The higher the
perceived risk by investors, the higher the implied volatility. Implied volatility is not
actually about the size of price swings, but is about the implied risk associated with
taking a market position.
Although VIX is commonly referred to as the fear index, an extremely low or
extended VIX suggests a high degree of complacency. Traders view extended levels of
low VIX as an indication that the nascent bull-run maybe coming to an end. To
contrast, an extremely high VIX may indicate a high level of anxiety, which may lead
to panic amongst traders.
The VIX is commonly watched by traders because it may often be used successfully to
time the market. VIX can be used together with a regular analysis of price action. A
trader could use VIX together with price action charts of the S & P 500, the Dow, and
the NASDAQ. Many traders use the VIX as a key indicator to gauge market direction,
health, strength and target price.
As any market technician will tell you, in prolonged periods where the VIX index
remains at low levels, it is time to become wary because this indicates investors have
become complacent. There is one market truism above all others: Markets will
change. There are many market road signs one can look to for guidance; the real
trick, however is knowing what these signs are and how to interpret them.
Market Road Signs The Trading Range
Like watching the VIX, analyzing a trading range, the spread or difference between
high and low prices during a given period of time, can be a boon to any savvy investor.
A trading range is generated by back and forth price movement between at least two
intermediate extremes. These price movements are the collective embodiment of all
investors knowledge and emotional attachments to an asset. A trading range
demonstrates how fear and greed can affect stock prices, directional moves within the
market, and, ultimately, directional change(s).
Richard Demille Wyckoff (November 2, 1873 March 19, 1934) was a stock market
authority. In 1907, he founded and edited the Magazine of Wall Street. He was also a
onetime editor of Stock Market Technique. Wyckoff implemented his methods in the
financial markets, and grew his account to the point that he eventually owned nine
and a half acres and a mansion next door to the estate of General Motors' industrialist
Alfred Sloan in the Hamptons area of Great Neck, New York.

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In the 1920s and 1930s, Wyckoff developed terms and working principles to analyze
trading ranges. Wyckoffs ideas established a school of thought that understanding
the context and principles of market movement were the keys to successful trading.
Continuing as a trader and educator in the stock, commodity and bond markets
throughout the early 1900s, Wyckoff was curious about the logic behind market
action. Through conversations, interviews and research of the successful traders of his
time, Wyckoff augmented and documented the methodology that he traded and
taught. Wyckoff worked with and studied all of the most important operators of the
day including himself, Jesse Livermore, E. H. Harriman, James R. Keene, Otto Kahn,
J.P. Morgan, and many others.
Wyckoff's research claimed many common characteristics among the greatest winning
stocks and market campaigners of the time. He analyzed these market operators and
their operations, and determined where risk and reward were optimal for trading. He
emphasized the placement of stop-losses at all times, the importance of controlling the
risk of any particular trade, and he demonstrated techniques used to campaign within
the large trend (bullish and bearish).
Wyckoff found that by analyzing a trading range, a trader could determine the
direction in which the ensuing move was likely to go. He established three
fundamental laws:
1.

The Law of Supply and Demandsimply stated, when demand is greater than
supply, prices rise. When supply is greater than demand, prices fall. This most
fundamental law is the basis for how the market works.

2. The Law of Cause and Effectassumes that in order to have an effect, there
first must be a cause.
3. The Law of Effort vs. Resultdivergences and disharmonies between volume
and price often presage a change in the direction of the price trend. The Wyckoff
Optimism vs. Pessimism index is an on-balanced volume-type indicator
helpful for identifying accumulation vs. distribution and gauging effort
Example of Primary and Secondary Trading Channels for the S&P500 from the March
2009 market lows thru mid February 2011:

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Wyckoffs analysis is a valuable tool in helping to establish a speculative position to

correctly anticipate a coming move where a favorable risk/ratio exits to justify taking
that position. In a trading range, the previous move has been halted, and there is
proportionate balance between supply and demand.
When analyzing a trading range, an investors first step is to uncover what the law of
supply and demand reveals (fear/greed). Sometimes, however, individual stock
movements, rallies or reactions do not reveal the effects of supply and demand. In
such a case, one must recall the law of Effort vs. Result and compare rallies and
reactions within a trading range to each other in terms of spread, volume, velocity and
price to gain. To be successful, one must correctly predict the direction and
magnitude of the coming move out of the trading range. Wyckoff defined five distinct
phases of accumulation and distribution to assist us in examining a trading range.
ACCUMULATION
Phase A
In Phase A, supply has been dominant, and it appears that the exhaustion of supply
(the ending of fear) is finally becoming evident. The approaching exhaustion of supply
or selling is evidenced in preliminary support (PS) and the selling climax (SC) where a
widening spread often reaches its peak and where heavy volume or frantic selling by
the public is being absorbed by larger professional interests. Once these intense
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selling pressures are over, an automatic rally (AR) follows the selling climax. A
successful secondary test on the downside shows less selling than on the SC and a
narrowing of spread and decreased volume. A successful secondary test (ST) should
stop around the same price level as the selling climax. The lows of the SC and the ST
and the high of the AR set the boundaries of the trading range (TR).
Phase B
In Phase B, supply and demand are balanced and there is no decisive trend. It is
more difficult to divine the future course of the market. Here, however, are some
useful generalizations.
Price swings in the early stages of Phase B have a tendency to be relatively sizable.
Volume is greater and somewhat unpredictable. Supply becomes weaker as the
trading range unfolds, and demand becomes stronger as professionals absorb supply.
As one gets closer to the end or exiting the trading range, volume is likely to diminish.
Phase C
In Phase C, the stock goes through a testing process. Either the stock begins to
emerge from the trading range on the upside with higher tops and bottoms or it could
experience a downside spring or shakeout. The downside is preferable, as it helps to
eliminate remaining supply from weak holders. Until this testing occurs, a trader
cannot be sure that the trading range is accumulation and needs to wait to take a
position for confirmation that a markup is nearing. If one has watched the trading
range carefully, this is the point where an upward move is highly likely. Supply is
apparently exhausted and the danger point is determined, so success is likely and a
traders reward/risk ratio is favorable. This sign of strength (SOS) brings us to Phase
D (greed).
Phase D
If ones analysis and timing have been correct, a consistent dominance of demand over
supply should follow here. Demand over supply will be demonstrated by a pattern of
advances on widening spreads and increasing volume, and reactions on smaller
spreads and weakening volumes. Unless this pattern occurs, it is not advisable to add
to ones position and look to close the original position until evidence points to the
beginning of a markup. There will be additional opportunities to add to ones position
when the stock progresses.
The goal in this phase is to establish a position or add to it just as the stock is ready
to leave the trading range. The force of accumulation has a good potential and may be
projected by using the Wyckoff method. This is the stage for which one has been
waiting to either initiate or add to a position to increase the probability of a favorable
outcome and maximize our trading capital. Phase D marks the best chance to add to
ones position before the stock leaves the trading range.
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Example of Accumulation Phase:

Phase E
Phase E is marked by demand being in control. The stock has now left the trading
range. A position has already been taken, so now one must monitor the stocks
progress as it works out its force of accumulation. This is where the stock enters the
markup phase where price increases occur driven principally by the emotion of greed
and secondly by fear of missing out on the chance to profit from the markup phase.
Example of Markup Phase:

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DISTRIBUTION
In distribution, the force of resistance (sometimes known as jumping the creek) is
replaced by the force of support (falling through the ice). The points where
differences between the phases of accumulation and the phases of distribution justify
discussion will be emphasized here, rather than revisiting each phase where some are
similar. Many of the principles and phases of a trading range preceding distribution
are the inverse of a trading range of accumulation. In general, distribution is
accomplished in less time than accumulation.
Phase A
Phase A is typified by demand having been dominant (excessive greed). The first
significant evidence of demand becoming exhausted comes at preliminary supply (PSY)
and at the buying climax (BC). It often occurs in wide price spread and at climactic
volume. This is usually followed by an automatic reaction (AR) and then a secondary
test (ST) of the BC, usually upon diminished volume. Phase A in distribution is
generally the inverse of Phase A in accumulation.
Similar to Phase A in accumulation, this phase in distribution may also end without
climactic action. The only evidence of exhaustion of demand is diminishing spread
and volume. Concerning redistribution (a trading range within a large continuing
downward move), one will see the stopping of a downward move with or without
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climactic action in Phase A.

In the remainder of the trading range, however, the
guiding principles and analysis within Phases B through E are the same as within a
trading range of a distribution market top.
Phase B
The objectives of Phase B are similar to those of Phase B in accumulation, although
there may be indicators of the supply/demand balance moving toward supply rather
than demand.
Phase C
After the standoff in Phase B, Phase C is revealed by the sign of weakness (SOW). A
SOW generally appears with significantly increased spread and volume to the
downside that appears to break the standoff in Phase B. The SOW may not fall
through the ice, but the subsequent rally back to the last point of supply (LPSY) is not
usually trustworthy and is probably on less spread and/or volume (beginning of new
fear cycle).
LPSY gives a trader a last opportunity to cover any remaining longs and a first
appealing opportunity to take a short position. An even more preferable point may be
on the rally that tests LPSY because it may give more evidence (diminished spread and
volume) and/or a more tightly defined danger point.
Phase C also can announce itself by a pronounced move upward, breaking through
the highs of the trading range. This is known as an up thrust after distribution
(UTAD).
Like a terminal shakeout in accumulation, a UTAD may be a
misinterpretation of the markets direction and allows further distribution at lofty
prices to new buyers. It also results in weak holders of short positions relinquishing
their positions to stronger players just before the down move begins. If the move to
new high ground is based on increasing volume and relative narrowing spread, and
price returns to the average level of closes of the TR, this would demonstrate lack of
solid demand and confirm that the breakout to the upside did not indicate a trading
range of accumulation, but rather a formation of distribution.
Phase D
Phase D is exhibited after the tests in Phase C show the end of demand. In Phase D,
the evidence of supply becoming dominant increases either with a break through the
ice or with a further SOW into the trading range after an up thrust.
Phase D also further proves the likely direction of the market and the opportunity to
take a first or an additional short position. The best opportunities are at rallies
representing LPSYs before a markdown cycle begins. An averaging in of the set of
positions taken within phases C and D represents a calculated approach to protect
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capital and maximize profit. It is important that additional short positions be added
or pyramided only if initial positions are in profit.
Example of Distribution Phase:

Phase E
In this final phase, the stock or commodity leaves the trading range (fear has taken
over). Supply is now in control. At this point, rallies tend to be weak. Having taken a
position, the key here is to monitor the stocks progress as it works out its distribution
force.
Usually after periods of distribution, the supply/demand ratio is decidedly negative
and a period of asset price declines ensue. This phase is known as a markdown.
During this phase, asset prices are marked down to a level where equilibrium is
restored to the supply and demand of the asset. Sometimes this phase is short;
sometimes the markdown phase can take several months. The length of time is
usually directly related to the degree of change during the markup phase.
The velocity of the price change is always greater during the markdown phase,
meaning prices fall much faster than they rose during the markup period. This is
caused by the multi-dimensional aspect of fear and the pain investors feel during
these periods.
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Example of a Markdown Phase:

The Cycle Continues

The only time that prices and the trading range are at rest comes at the closing bell.
Otherwise, investor emotions and perceptions constantly push asset prices to different
levels. After one market cycle has been completed, another immediately begins. This
could lead to further price declines following a re-distribution phase or it could lead to
a new markup phase as shown in the next graph. Either way, investors should be
aware of the signs the market is giving them and invest accordingly.
Example of Full Cycle:

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Conclusion
Clearly, there are numerous theories available to assist traders in profiting from the
market(s). There is fundamental analysis where analysts study the financial and
operating profiles of industries and companies to determine the prospects for future
profitability and thus what the forecast for the proper asset price should be.
Some traders invest based on factors such as which sectors and companies will
perform better based on points in economic cycles and seasonality of earnings.
Some investors prefer domestic investments to foreign and some investors prefer
foreign investments to domestic. There are many types of investment styles and many
different investors who employ these different strategies.
All of these attitudes, beliefs and perceptions form the basis of the market. If one
investor bought a share of any kind, another investor sold it to them. Clearly, those
two investors had opposing views of the investability of an asset at that time. The
buyer believed the price was attractive and would likely rise (greed). Conversely, the
seller believed the asset price was too high and, fearing a price decline, accordingly
sold.
This interaction plays out each trading day with innumerable market
participants throughout the markets across the world.
The market is the amalgamation of all of the emotions and beliefs of the participants.
All of these participants are human and are thus subject to the same factors that
affect each of us. Therefore, it is important for a trader to recognize the importance of
the emotional forces at work (greed and fear) as a key determination of where prices go
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and to keep in mind that, likewise, it is the perceptions of investors that create these
emotional drivers in the first place.

About Portfolio Research Partners, LLC

Portfolio Research Partners, LLC (PRP) was formed to bring to market trading strategies that the principles use personally to
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Glossary of Terms
Accumulation: An area where stocks are purchased or accumulated -- with the
intention to mark up prices at some later time. Every traded stock is in one of four
phases: accumulation, mark-up, distribution, or mark-down. Absorption is a form of
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"re-accumulation" which occurs toward the end of the Mark-up phase as price
approaches old resistance. Buyers "absorb" the offerings of bulls who bought at that
old resistance and now want out, as well as the offerings of bears who bought on the
way down to that old resistance and now see an opportunity to get out even.
Buying Climax: The opposite of a Selling Climax.
Composite Operator: Wyckoffs term for the total sum of forces, including the public,
that moves the market.
Demand: Buying power, buying pressure.
Demand Line: The line which identifies the angle of advance of a bull swing by
passing through two successive points of support (the low points of two successive
reactions).
Distribution: An area where stocks are sold with the intention to mark down prices at
some later time.
Mark-down: The phase of the cycle where prices decline, from the beginning of a bear
campaign to its bottom.
Mark-up: The phase of the cycle where prices rise, from the beginning of a bull
campaign to its top.
Price movement (price action): the continuous tick-by-tick (transaction-bytransaction) movement of price as shown on the tape (or on a corresponding chart).
Rally: A phase in the market that experiences rising prices or higher highs and higher
lows.
Reaction: A phase in the market that experiences declining prices or lower highs and
lower lows.
Resistance: An area where selling pressure overwhelms buying pressure.
Secondary Reaction: The reaction following a technical rally.
Selling Climax: A major panic that occurs at the end of a steep decline in prices.
Shakeout: A sudden break below a support level followed by a rapid reversal.
Springboard: A stock (or group or the market as a whole) is on the springboard
following a period of preparation for an advance or decline.
Stop Loss: An order to exit a trade if the market does something that proves your
initial decision to enter the trade as wrong.
Supply: Selling power, selling pressure.
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Supply Line: The line which identifies the angle of decline of a bear swing by passing
through two successive points of resistance (tops of rallies).
Support: An area where buying pressure overwhelms selling pressure.
Tape: A thin strip of paper on which is printed a series of stock symbols, each print
representing a transaction in that stock and consisting of the price at which the
transaction took place and the volume of shares changing hands. Modern day
equivalents are the "time-and-sales window" and the one-tick chart.
Tape Reading: The art of determining the immediate course or trend of prices from
the action of the market as it appears on the tape of the stock ticker.
Technical Rally: The rally that occurs after a selling climax.
Thrust: A break above a resistance level followed by a rapid reversal.
Trading Range: A period of balance between supply and demand forces. Prices move
within a range where the bottom represents demand and the top represents supply.
Trendlines: Straight lines drawn through the tops or bottoms of the price path
established during an upward climb or downward pitch. They serve to define the stride
of the price movement, thereby frequently directing our attention either to possibilities
of an approaching change of trend or to an actual reversal.
Volume: Number of units changing hands in each transaction.

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