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A Tutorial to Volume Weighted Average Price (VWAP)
The Volume Weighted Average Price (VWAP) is a widely-used technical indicator that many traders use to determine fair intraday prices and optimise trade execution. It’s especially useful for mutual fund managers who need to buy a large number of shares of one company.
Retail traders look at VWAP to understand intraday price fairness and gauge short-term movement. Day traders use it to spot the average market price, often buying when the price is below the VWAP and selling when it’s above.
In simple terms, VWAP helps traders cut through the ups and downs of price changes during the day. It shows a fair average price for a stock, helping investors make better decisions about when to buy or sell.
Key Takeaways
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The single line that appears on intraday charts is the volume-weighted average price (VWAP).
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Price action across a single day’s trading session is reflected clearly with VWAP.
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VWAP is largely used by retail and professional traders to determine intraday price trends.
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A trading benchmark, volume-weighted average price (VWAP), is most beneficial for short-term traders.
What is VWAP in the Stock Market?
In the stock market, VWAP is a technical indicator that shows the average trading price of security for a limited period of time. This is done after it is adjusted for the trading volume. VWAP is one of the most reliable measures for average trading price for intraday traders. This is because VWAP indicator accounts for the volume of securities traded.
Understanding the Volume-Weighted Average Price
Now that we know what VWAP means in the stock market, it's vital to understand the indicator.
A strong indicator, the volume-weighted average price changes as the units of security are bought and sold. It adjusts the average price on the trading volume, and smooths out price fluctuations over time, and evens out the trading noises. To put it simply, it provides traders and investors with a mean volume-adjusted price value.
This single line on the price chart of a security is used by both intraday and short-term traders for the identification of trends. Based on how the security price interacts with the volume-weighted average price, traders enter positions.
Calculation of Volume Weighted Average Price
VWAP = Cumulative (Price * Volume) ÷ (Cumulative Volume)
VWAP takes into consideration both price and volume of a stock. This is because volume indicates whether it is a good stock to buy or not. A stock that 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 the price and demand of an asset. However, standard VWAP is primarily an intraday indicator that resets at the start of each trading day, though moving VWAP can be used over longer periods.
Calculating VWAP
Calculating VWAP involves the following steps.
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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 the trader’s desire.
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Multiply the typical value or TP by volume (V)
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VWAP is the 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 calculates VWAP over a longer timeframe, such as multiple days or weeks, rather than resetting daily.
How to Interpret a VWAP Indicator
The movement of a stock price within a specific period of time can be better understood with the volume-weighted average price. By showcasing where most of the trading activities are taking place, it enables traders to maintain a track of the momentum and direction of the market.
VWAP cross:
A VWAP cross happens when the stock price moves above or below the VWAP line.
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When the price crosses above VWAP, it’s often seen as a bullish signal (buyers gaining control).
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When it drops below, it may indicate a bearish trend (sellers taking over).
Traders use these cross points to decide when to enter or exit a trade.
Trade fill:
A trade fill is when an order to buy or sell a stock is actually completed. VWAP helps traders make better trade decisions by aiming to get a fill price close to the day’s VWAP, ensuring a fair and efficient trade, especially for large orders.
Typical Price Indicator
The Typical Price Indicator is a basic formula that helps calculate VWAP. It’s found by taking the average of a stock’s high, low, and closing prices for a certain period.
Formula: Typical Price= (High+Low+Close) / 3
This gives traders an idea of the average price level for that time frame, which is then used to compute VWAP.
Importance of VWAP
VWAP can be extremely useful for the following reasons.
Market Assessment
If a stock’s price is above the VWAP line, it usually means the market is bullish. This means that the buyers are in control and the price trend is moving upward. If the price is below the VWAP line, it signals a bearish trend. This indicates sellers are stronger and the price may be heading down.
Deciding When to Enter or Exit a Trade
VWAP is used by a large number of traders to decide the right time to buy or sell a stock. It helps them avoid impulsive or emotional trades.
For example, investors mostly want to buy stocks trading below the VWAP, as these are considered cheaper than the day’s average price. With VWAP, they can choose the right moment instead of rushing in.
Better than Simple Moving Averages
While moving averages are commonly used to spot price trends, VWAP is often more accurate. The main reason is that VWAP takes both price and trading volume into account. It gives more importance (weight) to prices where more shares were traded. This makes VWAP more reliable, especially during times of big price swings or high trading activity, and helps traders trust their analysis more.
VWAP vs Moving VWAP
VWAP is an intraday indicator that 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, as it provides indications over an extended period.
Both VWAP and moving VWAP are great tools. To get an idea of price reversal in real-time, traders use the 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 a 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 a price reversal trade, moving VWAP is often used with an envelope channel for a 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 like any other trading tool, basing your trading strategy solely on VWAP may contradict the 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 the derivative oscillator stays above zero.
Entering a short position:
Moving VWAP is negatively sloped with the derivative oscillator below zero.
Exit trade if any of the two criteria are invalidated.
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
VWAP line is also used to find market support or resistance levels. 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. 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
The Volume Weighted Average Price (VWAP) is an essential indicator. It enables traders to understand a stock’s true average price based on both volume and price. It shows where most trading activity has occurred during the day, helping traders identify the right entry and exit points. By understanding VWAP, investors can move past the market sentiment, detect momentum shifts, and make more informed trading decisions.
VWAP is widely used in technical analysis alongside moving averages and other indicators. It not only highlights whether a stock is trading at a fair value but also signals bullish or bearish trends depending on its position relative to the VWAP line.
Traders also pair VWAP with other volume-based tools like the Positive Volume Index (PVI) and the Negative Volume Index (NVI). While the PVI tracks market behaviour when trading volumes rise, the Negative Volume Index helps analyse price movements during low-volume periods, offering a broader view of market dynamics.
In short, VWAP is more than just a calculation; it’s a crucial guide for understanding price trends, market demand, and trading momentum, helping traders make smarter, data-driven decisions in the stock market.