What Are Common Strategies for Using Volume Weighted Average Price?

What Is Volume-Weighted Average Price (VWAP)?

Volume-weighted average price (VWAP) is a commonly used benchmark derived from a ratio of the average share price for a stock compared to total volume of shares traded over a particular time frame. This measure helps investors and analysts evaluate the current price of a stock and determine whether it is relatively overpriced or underpriced compared to the average trading price for the day. Often this information is used to facilitate the entry or exit of a position.

The VWAP is used as a benchmark to determine the quality of executions in large orders. For example, if a portfolio manager wants to acquire thousands of shares, but also wants to purchase the position below the average price for the day, the VWAP will usually be the price to beat. A trader tasked with acquiring such a large position will be considered successful based on a comparison between the average purchase price and the VWAP at the time the position was accumulated.

Key Takeaways:

• Volume-weighted average price (VWAP) is a ratio of the cumulative share price to the cumulative volume traded over a given time period.
• The measure often serves as a benchmark for comparing trade executions.
• The VWAP uses intraday data.
• Some traders use the VWAP to indicate the timing of buy and sell signals for intraday trading.

Understanding Volume-Weighted Average Price (VWAP)

VWAP is an intraday price measure that can be used to help investors decide whether to adopt an active or passive approach to position entries. It can also be useful for making decisions on whether to enter or exit a given security. Many traders use the VWAP to help them buy at relatively inexpensive prices, and sell at comparatively higher prices.

Calculating Volume-weighted Average Price (VWAP)

The VWAP is calculated using the opening price for each day and adjusting in real time right up until the close of the session. Thus, the calculation uses intraday data only. The formula for calculating VWAP is as follows:

VWAP = (Cumulative typical price x volume)/cumulative volume

The calculation begins with the Typical Price (TP) price of the first completed bar or candle on the chart which means it is dependent on the time frame of the chart being observed. For example, on a five-minute chart, this would be the Typical Price of the first five-minute bar or candle. This price level is the average of the high price, the low price, and the closing price of the candle. Consider the following example using these pre-selected inputs: [(H+L+C)/3], if H = 44.54, L = 43.96 and C = 44.28.

TP = (44.54+43.96+44.28) / 3 = 44.26

The next step in the VWAP calculation is to multiply TP by the volume (V) in the period being measured to find the Total Price Volume (TPV). If V = 35,000, then TPV calculates as follows:

TPV = 44.26* 35000 = 1549000

The VWAP for the first candle ends up being the Typical Price because the volume component cancels out in the first iteration of the calculation. However, things change for the next candle. The formula then calculates cumulative price and volume in the following procedure for the second candle and similarly for each subsequent candle thereafter:

[TPV(Candle 1) + TPV (Candle 2]) / [V (Candle 1) + V (Candle 2)]

If we suppose that the second candle closed with a typical price of 43.96, and a volume of 32000, the price and volume product for the second candle would be 1,406,720. This amount would be added to the TPV for the first candle. The VWAP keeps the running total of the volume and price information aggregated throughout the day to give the current VWAP in real time.

Thus, to continue the example, the VWAP can be calculated by dividing the TPV sum by the cumulative volume amount of 67000 (35,000 from Candle 1 and 32,000 from Candle 2). Therefore, the VWAP after the second candle would be obtained as follows:

VWAP = 1549000 + 1406720 / 67000 = 44.11

This indicator is calculated for any time period to show the VWAP for every data point in an intraday stock chart. This is done automatically by charting platform algorithms. Thus, the trader only needs to specify an intraday time frame to see the results of the VWAP calculation.

The Significance of VWAP

Because it combines price and volume together in its value, most analysts consider the VWAP to be more representative of a true average price of the stock. The calculation of the VWAP is independent from, and does not directly affect, the stock’s closing price.

Since the VWAP calculation is based on historical data it is still considered a lagging indicator, but that doesn’t stop traders from using this measure to establish support and resistance levels suitable for intraday trading. In addition to this, because institutional traders use the VWAP as a benchmark for execution activity, the VWAP price level is considered to be highly influential in intraday price action.

Applying the VWAP

For the reasons previously mentioned, most professional traders agree that the VWAP is influential and useful when trading in short-term timeframes. Strategies for intraday trading using the VWAP might be as simple as buying the first closing price above VWAP as an entry, and selling at a predetermined point above it. But more often than not, the strategies for trading hold a bit more complexity than that.

The reason for this is the widespread belief among professional and nonprofessional traders that enough institutional traders use the VWAP as a benchmark. Traders often believe that a recognition of this dynamic must be factored into the trading strategy.

As a result, a trader might use VWAP as a filter for their activity. They might go long only when the price is below the VWAP and short when the price is above VWAP. This filter would be based on the point of view that benchmark-beating buyers are more likely to create support when the price is below VWAP, than when it is above it. This filter would work well for days with relatively sideways price action.

By contrast, other trades might prefer the opposite tactic. They would thus assume entries for buying a stock should only occur when the price is above the VWAP and short-selling entries should only be undertaken when the price is below it. This filter would be based on the point of view that benchmark watchers are unable to get the price they want and will be forced to push the stock further into its trend for the day. This filter would work well for days that had a well-defined trend for the day, whether upward or downward.

Neither tactic executed over a large number of trades appears to hold a statistical edge. Therefore traders often combine their VWAP approaches with other indications. That helps them to work with a more profitable filter depending on how they perceive the day’s price action will play out.

For example, a trader can also use the VWAP in conjunction with Bollinger Bands. These are a set of trendlines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of a security’s price that can be adjusted to user preferences. Traders may enter into a trade based on a VWAP signal and exit the trade based on a Bollinger Band signal, or vice versa.

Perhaps the most interesting use of the VWAP trade comes from programmers who have created a standard deviation of price range anchored to the VWAP. This creates price regions above and below the VWAP which make for surprisingly robust, real-time support and resistance measures (see example below).

Chart and VWAP Trading Example

Consider the following hypothetical example of a more sophisticated version of VWAP representation. This chart below depicts a 5-minute time frame during a period of just over two-days duration (click on the graphic for an enlarged chart). The VWAP line shown here (blue line) makes for an excellent intraday strategy filter. Not all days trade like this, but these two days represented a fairly sideways price action, and under such conditions, intraday traders like to have a game plan. A strategy to make trades based on a reversion to the average price for the day would work well here. In this setting, the VWAP indicator becomes very useful.

When additional regions are added to the chart that represent statistically significant distances from the VWAP line, they can make excellent guidelines for when to initiate long positions (in support regions) or to initial short-selling positions (in resistance regions). One approach for trading might be to initiate a long entry when the price closes in a support region, with a stop-loss order outside the farthest line of the region, and a profit target at the VWAP line. A similar setup for short-selling at resistance can also be employed.

This method will fail quickly on trending days, and make multiple successful trades on sideways days. Note also that the support and resistance regions from previous days can also be significant markets for future days when the price is moving sideways.

Read the original article on Investopedia.