The volume-weighted average price (VWAP) is a powerful technical analysis indicator prominently used on intraday charts, which resets at the beginning of each new trading session. It is a benchmark that illustrates the average price at which a security has traded throughout the day, heavily incorporating both volume and price. Traders leverage the VWAP to gain insights into the trend and intrinsic value of a security.
Key Takeaways
- VWAP is a dynamic line on intraday charts, resembling a smoother version of a moving average.
- It encapsulates the price action of a single day’s trading session.
- Numerous traders, both retail and professional, utilize VWAP to discern intraday price trends.
- It is especially beneficial for short-term traders seeking precise trade entries and exits.
Understanding the Volume-Weighted Average Price (VWAP)
VWAP is computed by summing the dollar value traded for each transaction (which is the product of the price and volume) and then dividing this sum by the total shares traded. Here is the formula:
VWAP = Cumulative Typical Price x Volume / Cumulative Volume
Where Typical Price = (High price + Low price + Closing Price) / 3
For clarification: Cumulative = Total since the trading session opened.
How to Calculate VWAP
Although many trading platforms automatically plot VWAP, calculating it manually enhances your understanding:
- Determine the average price the stock has traded at over the first five-minute period of the day. Add the highs, lows, and close, then divide by three. Multiply this by volume for that period to get the Period Volume (PV). Record in a spreadsheet under column PV.
- Divide PV by the volume for that period. The result is the VWAP.
- To keep VWAP updated during the day, continuously add each period’s PV value to the prior values. Divide this cumulative total by the cumulative volume up to that point.
Practical Uses of VWAP
VWAP serves varied purposes for traders. It acts as a trend confirmation tool allowing traders to set rules around it. For example, stocks trading below VWAP are often deemed undervalued, and those above it as overvalued. Thus, traders might opt to buy stocks below VWAP or sell them once they cross above it.
Institutional buyers, particularly mutual funds, utilize VWAP to accumulate or reduce positions causing the least market disruption. Buying below the VWAP minimizes price hikes due to their trades, whereas selling above mitigates price falls.
Note
VWAP provides substantial insights into trading activity by integrating volume, enabling traders to discern high-participation trends or low-activity setups.
VWAP vs. Simple Moving Average
While VWAP and a [simple moving average (SMA)] appear similarly on charts, they differ significantly. VWAP factors in volume and is calculated by multiplying the typical price by volume then dividing by total volume. Conversely, a simple moving average calculates average price without considering volume, which can lack the depth VWAP offers.
Constraints of VWAP
VWAP is limited to a single trading day, resetting anew each session. Averaging VWAP across multiple days could produce mismatched signals. Being volume-based also means, during strong trends, waiting for the price to dip below VWAP may result in missed opportunities.
VWAP uses historical prices, which makes it a lagging indicator, sometimes appearing as a moving average due to intrinsic lag.
What VWAP Signals
VWAP indicates the weighted average price adjusted for volume, revealing liquidity and price consensus among buyers and sellers. It serves as a pivot for assessing price movements during trading sessions.
Importance of VWAP
VWAP provides traders with essential insights on security pricing amidst trading activity, safeguarding against purchasing securities too expensively or selling them too low for the overall market trend.
For instance, a hedge fund might only buy securities when prices are at or under the VWAP to avoid pushing prices artificially upward; similarly, they sell above VWAP preventing substantial price drops from large sell orders.
Is VWAP a Leading Indicator?
No, VWAP is classified as a lagging indicator because it relies solely on historical price data. Although valuable, it isn’t suitable for forecasting imminent moves.
Conclusion
VWAP stands out as an indispensable technical tool for gauging the average price level of securities using both price and volume data, aiding traders in liquidity management and price assessment throughout intraday trading.
Related Terms: simple moving average, SMA, technical indicators, day trading strategies, stock trading, average price.
