VWAP (Volume Weighted Average Price) overview. Uncomplicated Moving Average
[info_block align="right"]When used with other trading indicators, it can definitely help to improve the accuracy of your trading strategy.[/info_block]
VWAP is an intraday calculation used primarily by HFT algorithms and institutional traders to estimate where stocks are trading relative to the average volume for the day. Intraday traders also use VWAP to estimate market direction and filter trading signals. Before using VWAP, you need to understand how it is calculated, how to interpret and use it, and what the disadvantages of this tool are.
How is VWAP calculated?
VWAP (Volume Weighted Average Price) is an abbreviation for Volume Weighted Average Price. At first glance, you might think that VWAP is just an average price indicator. But VWAP is more than that.
A moving average indicator is most often based on only one (closing) price of an asset, and it will never give you accurate information about the true average price. To determine the true average price of a stock (or other asset), you need the actual number of transactions over a range of prices. This is what VWAP can do.
Calculation of VWAP for any trading instrument is carried out by the following formula:
The classic VWAP calculation consists of five simple steps:
- The Typical Price [(H + L + C) / 3] is calculated based on the price data (OHLC). You can also select other calculated prices (see Settings on the PTMC platform).
- Calculated by the product of volume and Typical Price
- The cumulative trade volume is calculated (this is the denominator in the VWAP formula)
- Calculates the total of the product of Typical Price on volume (this is the numerator in the formula VWAP)
- VWAP value is calculated (divide step 4 by step 3)
В RTMS platform you can choose to calculate VWAP not only by price Open, High, Low, Close, but also by other types:
- Typical price is the average price [(H + L + C) / 3].
- Median price is the average price [(H + L) / 2],
- Weighted price is the average price [(O + H + L + C) / 4].
Traditionally, institutional traders calculate VWAP based on tick data for the whole trading day. But it is also possible to calculate for different timeframes (1, 5, 10, 15, 30 or 60 minutes, as well as week, month). All these settings can be set in the RTMS platform.
Trading with VWAP
Calculation of VWAP when using a daily cycle starts with the opening price of the trading day (you can also set the calculation time for a separate trading session), and at first VWAP will be very sensitive to price changes. But as you trade during the day it will become more stable.
When you use VWAP, you must keep in mind when the price is above the line, it means that the upward trend. Conversely, if the price is lower than VWAP, then the prevailing downtrend.
You are probably wondering what the behavior of this indicator is when used on a sideways market. In this case, the VWAP will simply project in the middle of the price range. By looking at the direction of the VWAP, you can figure out if you should use a trend or return strategy.
The following figures show how the VWAP looks like on the TSLA (Tesla company) chart for a bull market (Fig. 3a), a bear market (Fig. 3b) and a sideways market (Fig. 3c), respectively.
How do professional traders use VWAP?
- Buy when the price is below VWAP because they can accumulate a position at a price that is better than the average market price.
- Close long positions and open short positions when the price is above VWAP.
VWAP is used by HFT traders to buy/sell at a point that would not cause a sudden movement in stock prices. It doesn't necessarily give trading signals, but it does help buy low and sell high. When used with other trading indicators it can definitely help in improving the accuracy of your trading strategy. You should understand that this is only one indicator out of thousands, which is taken into account when placing a large volume of orders.
The strategy of retail traders who use VWAP
Retail traders want to trade often on impulse movements. When the price crosses the VWAP line, you can see it as an uptrend signal. And then you can look for buying opportunities. Conversely, you can consider sell signals if the price is below the VWAP line.
When you choose this strategy, you should know that:
- Strong buying pressure above VWAP shows that the price is forcing market participants to reach a new high.
- Strong selling pressure below VWAP is a sign that price is being pushed down to hit a new low.
The chart below (Figure 4) shows the interaction between the VWAP line and price. The VWAP is often support or resistance. This means that you can use the VWAP in your strategy to identify dynamic support and resistance levels.
Disadvantages of VWAP
There is no doubt that VWAP is a great indicator that you can use to enter profitable positions. But it is not a holy grail that will make you successful without any effort on your part. The main drawback of the VWAP indicator (like any MA) is that it Lags. This is due to its cumulative formula.
Let's clarify this with an example: if you use a 5-minute chart, after 4 hours of trading, the VWAP will be calculated for 48 periods. The lag associated with this will be similar to a 48 period moving average (Figure 5). As volume accumulates throughout the day, this lag will increase, and at the end of the day it will reach its highest value. This is due to the fact that so much data is already factored into the calculation that new data has very little impact.
Therefore, VWAP has more value early in the day for retailers because it is more sensitive to price movements.
On the other hand, at the end of the day VWAP will be smoothed and will be of little use for the retail trader. The values of VWAP at the end of the day are more important for the institutional trader, because the indicator gives a reference point, with which they can compare their accumulated positions relative to the average market price.