By Brian Nibley ·September 12, 2023 · 8 minute read
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The volume-weighted average price indicator (VWAP) is a short-term trend indicator used on intraday charts. It measures the average price of a stock weighted by trading volume and price, and shows up as a single line.
Professionals and retail traders alike can use the VWAP as a benchmark to aid their trading strategies by using this indicator to identify liquidity points, or as part of a broader trend confirmation strategy.
VWAP also helps determine the target price for a particular asset, helping traders determine when to enter or exit a position. VWAP restarts at the opening of each new trading session, and is thus considered a single-day indicator.
What Is Volume-Weighted Average Price (VWAP)?
The volume-weighted average price (VWAP) is a technical indicator that shows a security’s average price during a specific trading period, adjusted for trading volume. In effect, it’s a measure of demand for that security.
It’s similar to the moving average indicator (MA), but because VWAP factors in trading volume, it’s a clearer indicator of the security’s value.
VWAP is calculated as the total amount traded for every transaction (price x volume) and divided by the total number of shares traded.
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Why Is VWAP Important?
VWAP is important to traders and financial institutions for a few reasons. They can use the VWAP in combination with different trading strategies because it helps determine whether an asset is over- or underpriced based on the current market.
VWAP also helps identify a target price for the security so traders can aim for the best exit or entry points, depending on the strategy they’re using.
This benefits day traders, but also comes into play during corporate acquisitions, or big institutional trades.
Accuracy
One reason traders use VWAP is because it removes some of the static around a security’s price movement, and thus this indicator can provide a more realistic view of a security’s price throughout the day.
Trend Confirmation
Traders can also use the volume-weighted average price to gauge the strength and momentum of a price trend or reversal. When a price is over the VWAP, it might be considered overvalued. When it’s below the VWAP it may be undervalued. Thus it’s possible to determine support and resistance levels using the VWAP.
Simplicity
In many ways VWAP is a quick and easy way to interpret a security’s price and trend, and decide whether to make a trade.
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How Is VWAP Used in Trading?
As a trend indicator, VWAP adds more context to a moving average (MA). Since a moving average does not take volume into account, it could potentially be misleading when relatively big price changes happen on low volume, or if relatively small price changes happen despite large volume.
In addition, moving averages aren’t always helpful for short-term traders, because MA’s require longer time frames to provide good information. The VWAP is made to be a short-term indicator, as it involves one data point for each “tick,” or time period of a selected chart (each minute on a 1-minute chart, for example).
There are several ways that investors use the VWAP when trading.
Institutional Investors
Large institutional investors and algorithm-based traders use the VWAP to make sure they don’t move the market too much when entering into large positions. Buying too many shares too quickly could create price jumps, making it more expensive to buy a security.
Instead, some institutions try to buy when prices fall below the VWAP, and either sell or pause purchases when prices rise above the VWAP, in an attempt to keep prices near their average.
Retail Traders
Retail investors use the VWAP as a tool to confirm trends. As noted above, the VWAP indicator is similar to a simple moving average with one key difference — VWAP includes trading volume, as the name implies. Why does this matter?
Moving averages (MA) simply calculate average closing prices for a given security over a particular period (e.g., 9-day MA, 50-day MA, 200-day MA, etc.). Adding volume to an indicator helps confirm the potential strength of a trend.
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How to Calculate VWAP
VWAP is a ratio that indicates the relationship between an asset’s price and its volume. When used as a technical indicator on a chart, the computer automatically calculates VWAP and displays it as a single line.
Investors can also calculate VWAP manually. The two main pieces of the equation include:
• Typical price + volume
• Cumulative volume
The formula for calculating VWAP equals the typical price (the average of the low price, the high price, and the closing price of the stock for a given day) multiplied by the number of shares traded in a given day, divided by the total number of shares traded (cumulative volume).
Calculated daily, VWAP begins when the markets open and ends each day when the markets close.
Calculating a 30-Day VWAP
The 30-day VWAP is equivalent to the average of the daily VWAP over a 30-day period. So, to calculate the 30-day VWAP, you would have to add up the daily closing VWAP for each day, then divide the total by 30.
How Do You Read a VWAP Chart?
As with most technical indicators, there are many different ways to interpret the VWAP. Some of the most common ways to use this indicator for price signals include establishing support and resistance, indicating a trend being overextended, or using VWAP in combination with a different indicator.
Support and Resistance
This might be one of the simplest and most objective ways to read a chart using VWAP. One method for reading a VWAP chart is to use the line as an indicator for short-term support and resistance levels. If prices break beneath support, this could indicate further weakness ahead. If prices break above resistance, this could indicate more bullish momentum is yet to come.
Support and resistance are commonly measured using historic points of price strength or weakness, but this becomes more difficult when time frames are very short. Traders may use a volume-weighted indicator like the VWAP to predict short-term moves.
Trend Overextended
When looking at the VWAP indicator on a short-term chart, there could be times when price action goes very far beyond the VWAP line.
If price quickly goes too far above the line on heavy volume, this could indicate that the security has become overbought, and traders might go short. If price quickly falls far below the line, this could indicate that the security has become oversold, and traders might go long.
Of course, there is a subjective component involved in determining the exact definition of “overextended.” Typically, however, investors assume that price tends to return to the VWAP line or close to it, so when prices go too far beyond this line one way or the other, they could eventually snap back.
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VWAP Plus MACD
As they do with many technical indicators, investors often use the VWAP indicator in conjunction with other data points.
Technical analysis can become more effective when using multiple indicators together. By confirming a trend in multiple ways, investors can feel more confident in their projections.
As an example, some traders like to look at the VWAP while also looking at the Moving Average Convergence Divergence (MACD).
If the MACD lines see a bullish crossover around the same time that prices become overextended to the downside beneath the VWAP line, this could indicate a buying opportunity. If the MACD shows a bearish crossover as prices stretch far above the VWAP line, this could indicate a good time to close out a trade or establish a short position.
Limitations of VWAP
The VWAP is useful for day traders because it’s based on that day’s trading data; it’s more difficult to use the VWAP over the course of many days, as that can distort the data.
VWAP is also a lagging indicator, so while it captures recent price changes, it’s less useful as a predictive measure.
Is VWAP Good for Swing Trading?
It’s impossible to explore the role of VWAP in trading without addressing swing trading with this indicator.
The VWAP tends to work well for short-term trading like day trading and short- to medium-term trading like swing trading, in which investors hold a position for anywhere from a few days to a few weeks.
Using the VWAP on a daily basis could potentially help swing traders determine whether to continue to hold their position. If a short-term chart consistently shows prices beneath the VWAP, this fact could combine with other information to help the trader decide when to sell.
A Cumulative Indicator
It’s important to note that VWAP is what’s known as a cumulative indicator, meaning the number of data points grows higher as the day goes on. There will be one data point for each measurement of time on a given chart, and as the day passes, these points accumulate.
A 5-minute chart would have 12 data points one hour after the market opens, 36 after 3 hours, and 84 by the time the market closes. For this reason, VWAP lags the price and the lag increases as time goes on.
The Takeaway
The volume-weighted average price (VWAP) is essentially a trading benchmark that captures the average intraday price of a given security, factoring in volume. It’s considered a technical indicator, and it’s important because it gives traders pricing insight into a security’s trend and value, making it most helpful for intraday analysis. It’s one data point among many that traders might use when devising their investment strategy.
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FAQ
What is the difference between the volume-weighted average price and a simple moving average (SMA)?
The simple moving average or SMA just shows the average price of a security over a period of time. The volume-weighted average price, or VWAP, factors in the asset’s trading volume over the course of the day as well, thus giving investors more information about demand and price trends.
How do you use VWAP in day trading?
Day traders often use VWAP to determine the target price of an asset, the better to determine the entry and exit points for trades, based on their current strategy, whether long or short.
What is the difference between Anchored VWAP vs VWAP?
Traditional VWAP always starts with the opening price of the day (VWAP is primarily used as an intraday metric), whereas anchored VWAP allows the trader to specify a certain price bar where they want their calculation to start.
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