VWAP (Volume-Weighted Average Price)

Introduction of VWAP

The stock market is second to none, as its daily trading volumes have shown. So, there is a lot of value to be had here. Only, what’s the catch, you might be wondering? 

Well, the catch is that, left to your own devices, navigating this landscape can be very challenging. But, fortunately, you have various indicators that can help make things a bit easier, if you know how to use them.

After all, this market goes through all manner of situations or circumstances, and understanding their relevance or implications would enable one to use them in their favor through making the right trading decisions. 

Usually, indicators tend to base their calculations around price. However, interestingly enough, you have indicators that are volume-centric, which base their calculations around volume instead. 

You have On-Balance Volume, Chaikin Money Flow, MFI, and many more. However, the indicator that we’ll be delving into is the Volume Weighted Average Price, or VWAP for short.

What is VWAP (Volume-Weighted Average Price)?

So, why is the VWAP even important? We’ll go into that a bit later, as you need to know what it is first! It’s a technical indicator that’s used on intraday charts, which, by the way, means that it resets at the beginning of each new trading session. 

Basically, it’s the average price that securities have been traded at across the day, based on price and volume.

The Purpose of VWAP

Now, with that initial query. VWAP is important due to it offering traders additional insights into both the security’s value and the price trend. 

In other words, it can assess market sentiments and may serve as a sort of institutional trading benchmark. So, as far as the main purpose goes, this is pretty much it.

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How is VWAP Calculated?

You shouldn’t need to calculate the VWAP yourself, since most prominent trading sites that offer the indicator will automatically do it for you. But if you’re curious about the matter, then read on.

VWAP Formula

The formula for calculating the VWAP looks a little something like this: 

VWAP = Cumulative Typical Price x Volume/Cumulative Volume

Here, the typical price is equal to the low, high, and closing prices all added together, with the result then divided by three. The term cumulative here refers to the total number of trades conducted with the opening of the trading session.

Steps to Calculate VWAP

Knowing the formula is one thing, but actively calculating the values for yourself is another. So, the first thing you need to do is find the period you want to calculate the values for, whether it be one day, five minutes, ten minutes, or more, but not over a single day. 

Then, just find the typical price for that period by using the formula we highlighted earlier, and multiply the result with the volume for that period. 

And finally, just divide that result with the volume for the period, and there you have it; the VWAP is calculated, and you can use your findings to your advantage, assuming you’re able to, of course.

Key Characteristics of VWAP

While you could calculate the VWAP for any period, it’s typically used as an intraday indicator, like we mentioned earlier.

It’s also a fair value benchmark, which just means that it’s used as this gauge by traders seeking to know whether they’re acquiring good execution prices, hence the term “fair value.”

How to Use VWAP in Trading

Now that you know what the VWAP indicator is all about, we can move on to some of the different ways you could actually use it in trading. So, let’s get into it then.

VWAP as a Support and Resistance Indicator

Among the simplest ways you can go about actually using the VWAP is to gauge resistance and support. But how when it’s just a simple line on a chart? Well, if the stock in question is trading over that line, it serves as a support level, and naturally, if it’s trading below the line, then it will be resistance. 

So, as you might have guessed by now, the direction that the VWAP line goes in would be an indication of the actual trend, which just means that it can be used as this de facto trend line.

VWAP and Market Sentiment

If there’s one thing that anyone could gauge from what we’ve said so far about the VWAP, it’s that it is the relationship between that VWAP line and the price itself that helps traders gauge the wider market sentiment or which direction the trend is heading towards. 

So, like with support or resistance levels, if the price is sitting over that line, then the market may be regarded as bullish, and if it’s sitting below, then bearish. 

This can be similar to how traders use MAs, short for moving averages. But one thing that’s different with the VWAP is how stable it is, which can make it simpler to identify trends.

VWAP and Trend Confirmation

Aside from trend confirmations, VWAP may even be used to signal reversals! So, if a price that’s trending over that line and then crosses below it could signal a bearish reversal. 

And if the exact opposite happens, then you have a bullish reversal, essentially. The signals are reinforced if the price fails to cross the VWAP again. 

If you’re a trader and a smart one, then looking for these points should be a top priority for you, and our positions should reflect or be relevant to those points accordingly.

VWAP and Large Traders

The “large traders” here, in case you weren’t aware, refer to institutional buyers, including the mutual fund ones. So, these traders like to use the VWAP indicator to help move out of or into stocks with as little of an impact on the market as possible. 

Hence, whenever they’re able to, these institutions try to purchase below the VWAP while selling above it. Through this way, whatever actions they may undertake would only serve to push that price back towards the average rather than away from it.

VWAP Strategies for Different Trading Styles

Interested to know how the VWAP relates to the most popular trading styles within the landscape? Then read on, as that is precisely what this section will cover.

Day Trading with VWAP

For the day traders, whose focus lies mainly on short-term gains, they may find the VWAP quite useful considering how it’s typically used within intraday charts. But what strategies would suit such a style? Well, there’s intraday scalping by identifying the support and resistance levels and acting accordingly.

Swing Trading with VWAP

But what about the swing traders? Considering how their focus is usually directed towards medium-to-long-term profitability, they may use the indicator for following trends and confirming entry and exit points, and these can be perfectly viable strategies for those who feel more comfortable with this style.

Long-Term Investing with VWAP

As for those whose preferences lie within the long-term aspects of stock trading, while their uses with this indicator may be limited compared to some of the other trading styles, they may still use it for analyzing fair value or institutional trading.

Advantages and Limitations of VWAP

Like any other technical indicator out there, there are limitations and benefits that you have to factor in when deciding whether or not you’re going to use it, which is why we’ll be looking at those here.

Benefits of Using VWAP

Starting off with those pros, there’s the fact that the VWAP can be a consistent benchmark when evaluating trading performance because of how it reflects actual market conditions with its factoring of trading depth and intensity. 

Then you have its suitability for intraday trading too, and it being a go-to tool for many institutions.

Limitations of VWAP

Now with the limitations. Firstly, it’s a lagging indicator, and while that’s not inherently bad, obviously, it does mean that it’s slow in its reactions, which implies that traders might have more accuracy at the cost of being late to entering markets. 

Then you have its very nature as an intraday indicator that comes into play too, as it means that it’s not exactly suitable for long-term analysis. And finally, the fact that it’s a volume-centric indicator means that it’s sensitive to volume, which means that the potential for false signals is still there.

Conclusion

So, to summarize, VWAP is a technical analytical indicator that traders usually use amidst single trading sessions. And why?

To determine a security’s average price, which is based around both volume and price. All in all, the insights it provides can be quite welcoming for those looking into the price movement and liquidity during a day.