The Secret Mindset
The VWAP is a trading benchmark that gives the average price a stock has traded based on both volume and price. It can be used to identify trends, confirm trends, determine entry and exit points, measure trading efficiency, and identify liquidity points. It helps institutions move into or out of stocks with minimal market impact and can also be used for breakout and pullback trades. It has limitations as it is a single-day indicator and based on historical values, but is best suited for intraday analysis on shorter-term charts.
Understanding the Volume Weighted Average Price (VWAP) Indicator for Trading
Introduction to VWAP
The volume weighted average price (VWAP) is a trading benchmark used by traders that gives the average price a stock has traded throughout the day, based on both volume and price. It is important because it provides traders with insight into both the trend and value of a security.
The Formula for VWAP
The formula for the volume weighted average price (VWAP) is simple; you add up the dollars traded for every transaction (the price multiplied by the number of shares traded) and then divide by the total shares traded.
Difference between VWAP and Moving Average
On a chart, VWAP and a moving average may look similar. However, these two indicators are calculating different things. VWAP is calculating the sum of price multiplied by volume, divided by total volume, while a simple moving average is calculated by summing up closing prices over a certain period and then dividing it by how many periods there are. Volume is not factored in.
VWAP and Moving Average Lag Price
The volume weighted average price (VWAP) appears as a single line on intraday charts (1 minute, 15 minute, and so on), similar to how a moving average looks. Like moving averages, VWAP lags price because it is an average based on past data. Despite this lag, you can compare VWAP with the current price to determine the general direction of intraday prices.
Using VWAP to Determine Trend
In general, intraday prices are falling when below VWAP and intraday prices are rising when above VWAP. A rising VWAP, with the price above the VWAP line, means the price is likely in a short term uptrend. A declining VWAP, with the price below the VWAP line, means the price is likely in a short term downtrend. However, you should not solely rely on VWAP to determine trend, since it is only showing a historical average, and not what is happening currently or in the future.
VWAP Use for Large Institutional Buyers and Mutual Funds
Large institutional buyers and mutual funds use the VWAP indicator to move into or out of stocks with a market impact as small as possible. They use VWAP to identify liquidity points. The idea is not to disrupt the market when entering large buy or sell orders. VWAP helps these institutions determine the liquid and illiquid price points for a specific security over a very short time period. Therefore, when possible, institutions will try to buy below the VWAP, or sell above it. This way their actions push the price back toward the average, instead of away from it.
VWAP Use to Measure Trading Efficiency
VWAP can also be used to measure trading efficiency. After buying or selling a stock, big market players can compare their price to VWAP values. A buy order executed below the VWAP value would be considered a good fill because the security was bought at a below average price. Conversely, a sell order executed above the VWAP would be considered a good fill because it was sold at an above average price.
VWAP Use for Retail Traders
Retail traders, on the other hand, tend to use VWAP more as a trend confirmation tool, similar to a moving average. When the price is above VWAP they look only to initiate long positions. When the price is below VWAP they only look to initiate short positions. This is why day traders love the VWAP indicator because often the price finds support and resistance around the VWAP. Knowing that other traders and algorithms are buying and selling around the VWAP line, if you combine the VWAP with simple price action, a VWAP strategy can help you find dynamic support and resistance levels in the market.
How to Trade with VWAP
Using VWAP for Breakouts
VWAP breakout setup is very simple. A bullish breakout is when a stock’s price moves above a previously strongly held resistance level, often with higher trading volume. This can signal that traders are excited about this move and the stock may go on an extended price run. But we are not looking for a breakout to new highs but a break above the VWAP itself with strength.
When it comes to a VWAP breakout, we look for periods when a stock price drops below the VWAP. This can often signal that buyers are exiting their long positions which lowers the price compared to the VWAP. This can potentially be a good situation to look for a long trade, with the expectation that the stock will soon bounce back and continue its upward movement. Essentially, you wait for the stock to test the VWAP to the downside. Next, you will want to look for the stock to close above the VWAP. You will then look to buy above the high of the candle that closed above the VWAP.
Using VWAP for Pullbacks
A pullback is where a stock that’s on an extended move upward or downward makes a small movement in the opposite direction. Pullbacks are a common price movement, especially in heavy trends. To trade a VWAP pullback setup, you have to find a stock that’s in a clear uptrend, consistently making higher highs and higher lows. The stock price makes a pullback to the downside, returning to the VWAP level on the chart. This is a chance to buy the stock at the daily average price. After you enter your long, you’re looking for the price to continue its uptrend, gradually pulling the VWAP up along with it.
Important Tips for VWAP Trading
If you use longer-term charts, such as the 30-minute or 60-minute, your VWAP data will greatly lag behind a shorter-term chart (like the 1-minute or 5-minute). On a longer-term chart, the speed at which the VWAP generates a signal could mean that you completely miss the move. So, if you use VWAP, opt for the shorter-term charts.
Also, you have to be smart with where you place your stop-loss. A common mistake is to place your stops a few points below the VWAP. You will be stopped out often if you place your stops close to the VWAP. There’s a smarter way. For instance, if you take a VWAP pullback trade, you should look to place your stop-loss on the other side of a key chart level. That level may be below a pivot point or previous strong support level. That way, you can use the VWAP to try to keep trading in the right direction but maintain a stop-loss at a logical level. Alternatively, if there’s no major level, you can also look to keep your stock on the other side of a recent swing point.
Limitations of VWAP
The Volume Weighted Average Price (VWAP) has its limitations. VWAP is considered a single-day indicator and is restarted at the open of each new trading day. Attempting to create an average VWAP over many days could mean that the average becomes distorted from the true VWAP reading. Also, don’t forget that VWAP is based on historical values and does not have predictive qualities. VWAP serves as a reference point for prices for one day. For this reason, it is best suited for intraday analysis.
Conclusion
In conclusion, VWAP is a simple yet powerful indicator for traders. By understanding it, you can use it as a tool for trend confirmation, trade entries and exits, and determining trading efficiency. However, it is important to note that VWAP is a single-day indicator and it has limitations. As with any trading strategy, risk management is key. Proper stop-loss placement and good trade management are necessary skills. With practice, VWAP can be a fantastic addition to your trading toolbox.
