A Tutorial To Volume Weighted Average Price (VWAP)
Volume weighted average price is known to be a versatile tool that is widely used by technical traders in finding good equities for investment. It is used by mutual fund portfolio managers when they have to buy a substantial number of a particular stock. Similarly, retail traders use VWAP to find the future potential of a stock, and intraday traders to determine the mean price in the market so they can buy a stock when the price is below VWAP.
It is a weighted average formula, which is widely used by analysts and traders alike to determine the demand for a stock both in terms of volume and price. For calculation purpose, it takes into consideration all the orders form the day and calculate the mean value. It can spread over a single time frame or multiple frames based on requirements.
VWAP has multiple usages, but mainly it is used by analysts and portfolio managers to eliminate noise caused by price fluctuations throughout the day and determine a fair price to buy or sell stocks. It gives traders an idea of how the stock traded during the day.
An essential component of a VWAP indicator is the VWAP line or VAWP cross, which occurs when the stock price crosses the value-weighted average price. We will gradually discuss more details of the volume weighted average price but before that, let’s find out how to calculate VWAP.
As the name suggests, it is a weighted average. There is a wide variety of weighted average indicators used in equity trading, and VWAP is one of them. It is calculated using the following formula.
VWAP = (Cumulative (Price * Volume) ÷ (Cumulative Volume)
VWAP takes into consideration both price and volume of a stock. But why? When the importance of price is easily understood, the inclusion of volume might confuse many. Well, volume indicates if it is a good stock to buy or not. A stock which enjoys good demand and price is a good bet. If for some stocks the price is attractive, but there is no volume of trading, it means the stock has no taker.
This weighted average allows traders to compare both price and demand of an asset. However, VWAP is essentially a daily trading indicator. It doesn’t appear in weekly or monthly trend charts.
How To Interprete A VWAP Indicator
VWAP gives a crucial indication to traders regarding the price movement of a stock like, it helps them identify the exact point in a time frame where the momentum lies. Let’s consider it with an example; a trader may be dealing with a stock that has failed to breakout above VWAP line several times due to constant selling pressure. So, he may want to know the exact point where the stock successfully breaks above VWAP indicator line or else, he may end up being on the wrong side of market momentum if he enters a short position.
Stocks lying below the VWAP line are considered ‘cheap’ or ‘of value’ and tell traders to enter a short position. Conversely, stock prices above the VWAP line are tagged ‘expensive’.
So, how to figure out when a price is moving above the VWAP line or below? A technical system can be programmed such that it combines candlestick chart and trend lines, drawn together. In a VWAAP chart, the trend line is treated similar to a support and resistance line, and the candlesticks represent price movement.
Moving VWAP is a moving average line that visually represents stock price movement against price. It tracks end-of-day VWAP over time and its time frame can be adjusted to include as many VWAPs as needed.
Point to note, that VWAP and Moving VWAP may not always work in concurrence.
For a better understanding of VWAP, let’s discuss a few more definitions in association with it.
VWAP cross:
It is a trading indicator. It occurs when a stock price crosses the VWAP line.
Trade fill:
It refers to executed order related to buying or selling of stocks.
Typical Price Indicator:
It is simply an average of the stock prices during a day, represented by a line graph. Some traders use it in the place of closing price to draw moving average price line.
Calculating VWAP
Calculating VWAP involves the following steps.
- Calculate the typical price (TP) for each period by adding high, low and closing price, and dividing it by three, [(H+L+C)/3]. Each candle represents a time frame, 5-minutes or 30-minutes as per trader’s desire.
- Multiply typical value or TP with volume (V)
- VWAP is Typical Price x Volume, divided by the cumulative volume
When it is calculated for over a period, it produces a volume weighted average price for each data point. Moving VWAP is the collection of different end-of-day VWAP values and averaging it out for the number of periods.
VWAP vs Moving VWAP
VWAP is an intraday-day indicator which usually lasts for minutes or hours, used by short-term traders. On the other hand, moving VWAP is a better option for long-term traders since it gives indications for an extended time period.
Both VWAP and moving VWAP are fascinating tools. To get an idea on price reversal in real-time, traders use VWAP indicator which they can adjust for a shorter time frame.
Conversely, traders who follow other moving trend lines like moving average or moving average proxies, find moving VWAP a viable tool for their strategy. The moving VWAP is also used by traders who follow price reversal strategy. And, for it, they follow a crossover strategy which suggests using a fast average to determine trend direction when it crosses over a slow average. During price reversal trade, moving VWAP is often used with envelope channel for better understanding of price movement.
Trading Strategy With VWAP
The general rule to use VWAP for trading is to follow the slope of the line, but for like any other trading tool, basing your trading strategy solely on VWAP may contradict with ongoing market sentiment. VWAP predictions must concur with other trading tools to confirm a trend reversal.
The thumb rule of trading with VWAP is as below.
Entering a long position:
Moving VWAP is positively sloped, and derivative oscillator stays above zero.
Entering a short position:
Moving VWAP is negatively sloped with derivative oscillator below zero.
Exit trade if any of the two criteria invalidate.
Using VWAP
VWAP gives an understanding of price and volume together, and so it has found multiple usages in modern trading.
VWAP for trend confirmation
VWAP can help traders understand any emerging trend. Whether it is rising or falling will indicate market sentiment. Even when the price is choppy, a smooth VWAP line is an identifier of an emerging trend.
VWAP Breakout
VWAP breakout signifies the moment when a stock price goes above the VWAP indicator, beating its average price. Traders enter a long position as bullish forces are strong in the market.
Finding Support And Resistance With VWAP
VWAP line is also used to find market support or resistance level. For instance, say the stock price started below the VWAP line and then made a few failed attempts to cross the VWAP line, then it can be treated as a resistance area. Similarly, when a stock price starts above the VWAP line and hesitates near the VWAP line, before moving up again, we can treat it as a support line.
Using VWAP To Execute A Trade
VWAP is used by institutional buyers to buy shares in bulk without causing market disruption. What does it mean? Let’s consider it with an example.
A mutual fund wants to buy 10,000 shares of a particular company. Now if it places an order for the block in one shot, it will spike the market as the exchange will try to fill. It will push the market up and increase demand for that stock, encouraging other traders to buy it at a higher price than the initial bid price of the mutual fund and sell it at an even higher value. To avoid the situation, the mutual fund will divide the total demand in small quantities and invest through an automated trading strategy which will allow the price to remain close to the VWAP line.
Conclusion
VWAP is a great tool that has multiple usages in technical trading. Traders use it with other moving average tools to find the right entry and exit points in the market. It allows you to understand market interest, price trend, demand, and a point of interest. Traders also use other indicators that are similar to VWAP. These are called the Positive Volume Index and the Negative Volume Index. These tools help trader form a fair understanding of market trend and demand to base their strategies.
