Do you know the Law of Cause and Effect in Trading?
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The law of cause and effect is one of the three basic laws that Richard Wyckoff introduced into financial markets. This law tells us that for there to be an effect, there must first be a cause that originates it.
The Law of Cause and Effect on Financial Markets
The idea is that something cannot happen out of nowhere; that to see a change in price, a root cause must first have been built.
Generally, causes are constructed through a major change of hands between well-informed and uninformed operators.
In the case of individual transactions, the cause for the price to rise is the buyer’s desire to want those shares or the seller’s desire to want that money.
In addition to seeing the cause in terms of an individual operation, the objective is to see the cause from a broader perspective, in terms of movements. For this, it is said that the market is constructing a cause during periods of price lateralization; and that these generate later as an effect a tendential movement to the rise or to the fall.
In these lateralization periods, stock absorption campaigns are carried out in which the big operators begin to position themselves on the right side of the market, gradually expelling the rest of the participants until they find the path on which the price will be directed free of resistance.
An important aspect of this law is that the effect realized by the cause will always be in direct proportion to that cause. Consequently, a great cause will produce a greater effect, and a small cause will result in a lesser effect.
The key is to understand that it is during the lateral price phases that the accumulation/distribution processes take place.
Depending on its duration and the efforts we see during its formation (manipulation manoeuvres such as shaking), this cause will provoke a response movement upwards or downwards (effect).
Elements to bear in mind
There are certain market conditions, such as climatic events, which can cause a sharp turn in the price without a great deal of preparation.
The big operators use these climate candles to accumulate/distribute all the stock they need without developing a more extensive campaign and starting from there the expected movement.
Another aspect to keep in mind is that not all trading ranges are accumulation or distribution processes. This point is very important.
Remember that the methodology tells us that there will be structures that are simply price fluctuations and do not have a motivating cause.
Point and Figure Charts
In principle the projection of the effect will be unknown, but we can propose it as proportional to the effort that provoked it.
Wyckoff used the point and figure graph to quantify cause and estimate effect.
By means of the horizontal counting of columns the possible objectives are estimated. It is about providing a good indication of how far a movement can go. Accumulation would produce an upward count while distribution would project it downward.
Unlike bar charts, which are time-based; point and figure charts are based on volatility.
In order for the dot and figure chart to advance to the right and generate a new column, it first requires a price movement in the opposite direction.
The count on this type of graph is made from right to left and is delimited between the two levels on which appeared first and lastly the force that controls the market at that time:
- For the projection of a count in an accumulation scheme we measure the number of columns between the Last Point of Support (last event on which the demand appears) and the Preliminary Support or Selling Clímax (first events of appearance of the demand).
- For the projection of a distribution count we measure the number of columns between the Last Point of Supply and the Preliminary Supply or Buying Clímax.
- For the reaccumulation trading ranges the count is made from the Last Point of Support to the Automatic Reaction (as this is the first event on which the demand appeared).
- For the redistribution trading ranges the count is made from the Last Point of Support to the Automatic Rally (the first event on which the offer appeared).
After counting the number of boxes that make up the range, the result is multiplied by the value of the box.
The classic projection is obtained by adding the resulting figure to the price on which the LPS/LPSY is produced.
To obtain a moderate projection, the resulting figure is added to the price of the highest extreme reached.
- In the distribution trading ranges, the highest maximum will generally be that set by the Upthrust (UT) or Buying Climax (BC).
- For the accumulation trading ranges, the lowest minimum will generally be the Spring (SP) or Selling Clímax (SC).
Get a more conservative projection by dividing the area into phases. Counts from and to where price turns occur. Count the number of boxes that make up each phase and multiply it by the value of the box. The resulting figure is added to the price of the LPS/LPSY or to the price of the highest extreme reached.
Just because the value has ample preparation does not mean that the whole area is accumulation or distribution. This is why point and figure counts do not always reach the objective of greatest scope and therefore it is suggested to divide the range in order to generate several counts and thus establish different objectives.
Technical analysis for projection of objectives
There are operators who consider that the projection of targets by counting the point and figure graph is not very operative in today’s markets.
There is also a problem with the point and figure at the time of its preparation because there are several ways to do it. This makes it useless from my point of view since this subjectivity makes me lose confidence in this tool.
Some of us prefer to simplify it and use tools such as Fibonacci, Elliot or harmonic patterns (vertical projection of the range) for the projection of targets.
This type of tools are becoming more and more powerful since since the inclusion of software in financial markets, many of the algorithms are programmed under these simple premises and therefore are objectives that are met with a high probability.
Since the market moves under this law of cause and effect by using the lateral phases to generate the subsequent movements, I believe that it can give us an advantage to try to decipher what is “baking” during the development of these structures.
And to try to figure out what’s going on there, the Wyckoff methodology gives us excellent tools.
Wyckoff traders know that it is in these lateral conditions from where the movements are born and that is why we are continuously looking for the beginning of new structures to begin to analyze the action of price and volume with the objective of positioning ourselves before the development of the trend movement.
A trend will end and a cause will begin. A cause will end and a trend will begin. The Wyckoff method is centered around the interpretation of these conditions.