The Volume-Weighted Average Price known also as VWAP is an efficient trading tool providing investors with an average asset price over a particular period based not only on the price itself but also on the asset volume. This indicator has gained immense popularity being relatively easy to use and easy to interpret. In this article, you’ll find a complete guide on the VWAP indicator: its key characteristics, calculation, examples of use, trading strategies, advantages, limitations, and more.
What Is Volume-Weighted Average Price (VWAP)?
The Volume-Weighted Average Price (VWAP) is a technical indicator that calculates the average asset price over a certain period (usually one day) weighting it against the cumulative volume of the security during that time. Being based on the previous data, VWAP is considered a lagging indicator, meaning that it doesn’t predict price moves but only reacts to them. On the price chart, it is presented by a single line, which makes it look familiar with the Moving Average.
Many traders and financial institutions apply the VWAP indicator to their trading strategies since it allows them to analyze the current market situation (whether the asset is overpriced or underpriced), define the target price for the particular security, and adjust their entry/exit points accordingly, this way increasing potential profits. The trade is supposed to be more efficient when investors buy the asset at a price lower than the VWAP value. Otherwise, if the asset trading price is over the VWAP, the trade is considered less profitable.
What Is the Difference Between the Volume-Weighted Average Price (VWAP) and a Simple Moving Average?
Both VWAP and Simple Moving Average (SMA) represent the asset price trend. However, the main difference between them is that VWAP takes into account not only the cumulative asset price but also the asset volume during the intraday period. SMA, in contrast, implies that the asset volume is the same for any trading day. Thus, in calculations, the SMA and VWAP will show slightly different results, whereas the latter will be more precise. What’s more, moving averages has proven to show better results on a long-term basis, VWAP, on the contrary, was created as a short-term trading indicator.
How Is VWAP Used In Trading?
VWAP often serves as a benchmark for both individual traders and large institutions, helping them to evaluate the efficiency of potential trades. Let’s have a closer look at how exactly they can use this indicator in their trading strategies.
Large instant trades with a big number of stocks or other securities (common among portfolio managers and mutual funds) may foster the asset price to go up. Being a volume-based indicator, VWAP allows large market players not to become the reason for significant asset price movements. They usually tend to open long positions when the price is below the VWAP and short positions when it is over the VWAP indicator, this way moving the asset value closer to the average and keeping the balance in the market.
Retail traders may use the VWAP indicator to understand the true average price of the asset and decide whether it’s a good moment to buy or sell. Moreover, by implementing VWAP, as well as SMA, traders can confirm the market trend. However, as mentioned before, the VWAP value is likely to be more accurate than the SMA result.
How To Calculate VWAP
Being a widespread indicator, VWAP can easily be found on the majority of trading platforms. Yet, if you want to figure it out on your own, here are the steps to follow. Note that all the calculations are done on the intraday timeframe.
- Calculate the average (typical) price during a chosen (short-term) timeframe. You need to sum the average high, low, and closing price and then divide it by 3.
Average (typical) price = (average high + average low + average close) / 3
- Multiply the result of the Average price by volume within the chosen period. As a result, you’ll receive a total price volume.
Total Price Volume (TPV) = Average (typical price) * Volume
- Calculate the cumulative total volume. You need to sum the TPV of the candles during the chosen timeframe and divide the result by the sum of volumes of those candles.
Cumulative Total Volume = (TPV (Candle 1) + TPV (Candle 2) + …) / (Volume (Candle 1) + Volume (Candle 2) +…)
- Find the value of VWAP using this formula:
VWAP = TPV / Cumulative Volume
What Are The Advantages of Using The Volume Weighted Average Price?
VWAP comes with a considerable number of benefits. Here are some of them.
- Accuracy. Based on not only trading price but also asset volume, VWAP provides investors with a more precise market picture in contrast to moving averages, for example.
- Can be used for large trades. Not only is VWAP efficient for individual investors who want to evaluate the market situation or confirm the trend, but also for large institutional players who can use VWAP to measure and balance their impact on the market.
- Efficient for short-term trades. In contrast to moving averages that are highly influenced by market noise, thus are preferable for middle- or long-term strategies, VWAP can smooth short-term market volatility and offer traders much clearer data.
What Are The Limitations of Using the Volume-Weighted Average Price?
Like any other trading tool, the volume-weighted average price indicator has its drawbacks. Let’s have a closer look at the most significant of them.
- Intraday indicator. VWAP fits best for the short-term or middle-term strategies and starts to lose its accuracy and efficiency on a long-term basis.
- Better efficiency when combined with other tools. Opening long positions when the asset price is below VWAP and short ones, when the price is above VWAP, may not be an effective strategy at all times. The price could continue staying over the VWAP line for a long time, thus, investors who rely only on this indicator could miss their potential trading opportunities.
- Lagging indicator. VWAP is based on previous data. It can’t foresee price movements, it only reacts to the established market trend. Thus, as mentioned before, it’s recommended to use it in combination with other technical indicators.
How To Read a VWAP Chart?
It’s important to note that the VWAP indicator is reset at the opening of each trading day. Therefore, paying attention to the chart, it’s possible to see a sharp move of the VWAP line at the beginning of the trading day and its smoothing closer to the end.
As mentioned above, by analyzing the VWAP indicator it’s possible to determine if the market is overpriced or underpriced and open buying or selling positions respectively. When the price is over the VWAP it’s a signal that the market is overbought. Otherwise, if the price is below the VWAP value the market is believed to be oversold. However, it doesn’t necessarily mean that you shouldn’t open a long position in the overbought market or a short position in the oversold market, it just implies that they will be more expensive. What’s more, it’s better to use other technical indicators along with VWAP to confirm buying/selling signals.
There are many other ways to read charts with the VWAP indicator. Let’s consider some of them.
Support and Resistance
VWAP indicator could serve as a simple form of support and resistance levels. When the price crosses the VWAP and goes above it, VWAP becomes a support line. This case could be interpreted as a possible continuation of the bullish trend. When the price breaks down the VWAP, it becomes the resistance line and may indicate that the bearish trend is here to come.
When the asset price increases or declines far beyond the average, this could be the signal for an overbought or oversold market. Traders tend to believe that after such bounces the price usually returns close to the average level. Therefore, this could be a reason for the investors to go long (if the price sharply decreased) and to go short (if the price sharply soared).
VWAP Plus MACD
Like any other indicator, VWAP is more effective when implemented in combination with other technical analysis tools. This way, traders could confirm their assumptions and improve the accuracy of their trading strategy. One of the widespread working mixes is VWAP and Moving Average Convergence Divergence (MACD). If the asset price is overextended below the VWAP value while the MACD indicator has experienced a bullish crossover close to that time, this situation could be a signal for investors to open buying positions. Conversely, if the price is overextended over the VWAP while MACD has a bearish crossover, traders might open short positions or close their existing long trades.
VWAP Trading Example
Knowing how to read the VWAP indicator on the chart, let’s consider a trading example in the stock market, where the VWAP will be used together with MACD.
In the price chart above, it’s possible to see that the VWAP indicator moves sharply at open, thus, it’s better to skip this period until the price gets smoother. When the MACD shows a bullish crossover while the asset price is located below the VWAP, it might be a signal (confirmed by both indicators) to open the long (buying) trade. The position could be held until the first bearish crossover of the MACD indicator.
Then, you can see that the price tests the support level and finally breaks out under VWAP. By analyzing MACD lines, we can confirm a bearish trend. It could be a signal to open a short (selling) trade that could be kept until the MACD doesn’t experience the opposite crossover.
VWAP Trading Strategies
VWAP is a widespread and relatively easy-to-understand technical tool. It could help investors find new trading opportunities while being a part of many different strategies. Here are the most common of them.
The VWAP Pullback
A pullback is a short-term reversal from the main trend. Therefore, the first thing to do is to identify the direction of the trend. This can be done with VWAP. When the asset price keeps floating under the VWAP line, it could be a sign that the market is in a downtrend. Otherwise, when the asset price is above the VWAP indicator, it’s believed to experience an uptrend. Moreover, to confirm the trend it’s possible to apply the Moving Average as well. After that, traders analyze a couple of first price candles and stay alarmed for the coming pullback to open a short or long trade depending on the main direction of the market.
Fade To VWAP
The fade strategy implies opening the opposite trade after the market movement with strong momentum. Analyzing the chart above, it’s possible to see that the price was going up and far away from the VWAP line. It has become overextended and failed to make a higher height. This could be a potentially good chance to enter the trade. However, don’t forget to pay attention to the volume. If there isn’t enough of it, the price wouldn’t be able to start an opposite trend.
When the market shows an uptrend traders are usually trying to open long positions. Conducting a retracement trade in such conditions, it’s necessary to wait for the price to drop below the VWAP indicator. This could be the first sign of the upcoming buying signal. As soon as the candle crosses the VWAP and closes above it, traders might open long positions starting from the next candle.
Regardless of the strategy, you’ll choose, it’s crucial to remember that VWAP is best for short-term trades. Thus, try not to use it for more than 24 hours and give preference to short-term price charts. What’s more, it’s better to use the VWAP indicator in conjunction with other technical tools based on other types of data. This way you’ll be able to confirm your assumptions and make your trades potentially more profitable.
A volume-Weighted Average Price is a popular tool among individual and institutional traders. VWAP accounts for both asset price and volume during a certain period (usually one day), which makes it a seamless instrument for intraday analysis. While individual traders could use it to spot potential entry/exit points, mutual funds could control their influence on the market.
Like any other technical tool VWAP comes with particular limitations, therefore, to achieve more accuracy in your trading strategy it’s better to implement it in combination with other indicators, such as MACD, RSI, and others.