A VWAP is an interesting market indicator for day traders to use. It can provide useful data to investors, letting them know when the right time is to open and close their positions. There is a lot more to a VWAP than that though. We break down how to use this kind of indicator and where it can best serve you.
What is Volume-Weighted Average Price?
The name may sound like a mouthful but VWAP is actually a simple premise. It is simply the price of stock weighted by the total trading volume. What this does, is determine the average price of a stock over a certain period of time.
The VWAP is a useful analysis indicator for investors. It helps traders understand when the best time is to enter or exit a position. This is because the VWAP sets a benchmark for the trader to compare the current price of a stock to. The VWAP is also useful for the trader to know when to take a more aggressive approach to a stock or when to remain more passive.
Understanding the VWAP formula
If done correctly, a VWAP formula should include every single trade made during a session. In theory, if you had all of that data, your formula would look like this:
- Sum of (Price x Volume for each Trade) ÷ Total Volume
However, having all of this data available to you does not typically happen. Instead, traders need to use a shortcut that is called the “typical price.” The typical price is equal to the average high, low and close of day price for an intraday period. The formula would then look like this:
- High + Low + Close ÷ 3
For each period, your typical price needs to be multiplied by the volume within the trade period. The figure you get from that is then divided by the total volume for that to, up to that point. In other words:
- Sum of (Typical Price x Volume) ÷ sum of volume
While this may seem complex at face value, you won’t need to concern yourself with the specifics when you are trading. Most of the time, the trader won’t need to calculate the VWAP as this is done automatically through the use of trading software. However, you will need to enter the number of periods to be considered in the VWAP calculation.
VWAP vs a simple moving average
Advantages of using VWAP
There are a few reasons why investors use a VWAP in their everyday trading. Let’s take a look at how a VWAP serves you.
Indicates whether markets are bearish or bullish
If a market is bullish, it means that a market is trending above the average, which will lead to an increased buying period. If the market is bearish, there is pressure to sell, as a stock’s price is on a downward trend. Knowing when a market is bearish or bullish gives an investor important information about the state of things.
Know when to buy or sell
As you can more effectively see when a market is bearish or bullish, you can then subsequently have a better idea about when to buy or sell. At the end of the day, VWAP helps investors make more informed decisions on when to open and close their positions.
Where VWAP falls short
Using VWAP has its advantages but there are a few shortcomings in using it as well. Here are a few factors to keep in mind.
Short use only
VWAP can only give you accurate information over a single day period. If you try to use VWAP over multiple days you can end up with data results that are skewed or distorted. It’s key to remember that using VWAP should only be over the course of a trading session or day. In addition to this, VWAP is based on historical information which means that it cannot be outright predictive. As a trading session or day wears on, you may notice increased lag in the data.
VWAP shouldn’t stand alone
It’s vital to remember that VWAP cannot and should not be your only indicator for your everyday trading. If you stick to buying stocks that trend below the VWAP, there is always the chance that you miss out on markets with strong uptrends. For example, if you always sell when a stock is above the VWAP, you may have missed out on an opportunity where the value of a stock would have continued to rise. That is why the best traders use VWAP in conjunction with other trading strategies.
Tips for using VWAP
As we already mentioned, the best traders will use VWAP in combination with other trading strategies. With that said, there are also a few things to consider to make sure that you use VWAP as effectively as you can.
Be wary of where you place your stop-loss
While most traders will keep their stop-loss order on the other side of a key price or level, those who use VWAP need to be more vigilant. This is because VWAP can move throughout the day. Instead of keeping your stop-loss on the other side of a specific price point, you would do well to keep it on the other side of a chart level or key swing point.
Never use VWAP for longer than 24-hours
As we mentioned earlier, a VWAP is really only good to use for a trading session or for a singular day. The VWAP data can be distorted if you try to use the same average for more than a few days. Make sure you only use VWAP for each individual trading session, this way, you know your data is as accurate as it can possibly be every time.
Using short term charts
When using VWAP, it’s all about staying up to date. There may be an event that sparks an upward trend in a market. Sometimes this can happen in the space of 5-minutes and by the end of it, you have already missed your chance to take advantage of the opportunity. If you use charts that work in increments of 30 or even 60 minutes, you are going to lag behind certain trends. Instead, make sure you use short term charts that use increments of 1 – 5 minutes.
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