Volume Weighted Average Price (VWAP) is a trading indicator that provides traders insights into the average price of a stock throughout the day based on price and volume. Traders usually use it to assess market trends. VWAP is handy for institutional investors and large traders looking to execute orders without causing much disturbance to stock prices.
Based on the price comparison with the VWAP, traders can decide to either buy or sell. A price above the VWAP line indicates a stronger trend, whereas a price that falls below it indicates weakness in a trend.
Continue reading this blog to gain detailed insights about VWAP meaning, features, benefits, trading strategies and more.
Volume Weighted Average Price (VWAP) Meaning
VWAP stands for volume-weighted average price. This is an important financial tool that reflects the ratio of the price of an asset to its total trading volume. It provides investors and traders with an accurate measure of the average price at which a stock is being traded over a specified period. VWAP is usually set as a benchmark for traders who want confirmation about whether a stock is bought and sold at a reasonable price.
This indicator is dynamic and thus keeps on changing as there is a rapid progression of trading sessions to make decisions about buying and selling. Usually, the calculation of volume-weighted average price is done on an intraday basis and is reset at the end of trading day.
What is the Formula for VWAP?
The formula used widely to calculate volume weight average price is as follows:
VWAP = (Cumulative (Price * Volume) ÷ (Cumulative Volume) VWAP
Where the current typical price is the summation of prices of all executed trades, and total volume is the sum of the volume of all executed trades for a day
Calculation of VWAP
To know how to calculate VWAP, the first and foremost step is to begin computing the price, which can be obtained by taking the average of high, low, and closing prices for a day. For example, if the high, low and closing price of a stock is ₹20, ₹16 and ₹18, the typical price will be calculated as:
Typical Price (TP) = ₹(20+16+18)/3 = ₹18
After the price is computed, the next step will be to multiply this number by the volume for the day. For example, if the volume for the day is 20, the result for multiplying the typical price by the volume will be 18*20 = 360
The total volume for the day can also be tracked by adding up the volume as it accumulates throughout the day. For example, if the cumulative volume for the day is 78, with the help of the VWAP formula, its VWAP is computed as 360/78 = 4.6
Every investor can compute VWAP in the stock chart by making calculations for each period. It is, however, not always necessary for investors to compute the VWAP manually, as many trading apps perform the task automatically. A trader only needs to mention the number of periods for easy computation of VWAP.
Significance of VWAP
VWAP is helpful for traders in numerous ways. Let’s explore them in detail below:
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Assessing if the Market is Trending Upwards or Downwards
If security is trading above the VWAP, it denotes a bullish market trend. Similarly, if its price is below the VWAP, the market trend appears bearish. In a bullish market, the rise in purchasing power causes an upward movement of the trend line, while a bearish market with selling pressure pulls down the trend line. These signal the significance of VWAP for investors and enable them to make informed choices considering market sentiments.
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Improvement in Moving Averages
Moving averages are a popular instrument for investors in the financial market to identify trends and opportunities to buy and sell positions. However, the VWAP is considered a more accurate representation of stock prices. This accuracy is possible to achieve because VWAP takes into consideration the trading volume of shares at different prices and assigns weightage to each price as per volume.
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Making Decisions for Entering or Exiting the Market
Most investors depend on VWAP as an important tool for deciding the market entry and exit. As traders search for stocks that are trading under the VWAP line, they follow a patient trading strategy and buy only when the average price is below the VWAP line. Thus, they end up not paying too high a price.
The VWAP line is a vital indicator that assists traders in entering the market at a comparatively lower price and yielding high profits.
Uses of VWAP in Trading
Traders consider using VWAP in several ways to make good decisions. One approach involves the use of VWAP as a tool for confirming trends and creating trading strategies based on it. Institutional buyers also rely on VWAP while entering or exiting stocks. As such, they often purchase stocks when their price is below VWAP and sell them when they are above VWAP.
If the price of a stock is below VWAP, traders may consider it undervalued. However, if a stock’s price is above VWAP, it is overvalued. If the price of stock moves above VWAP, traders might choose to continue, while if the price moves below VWAP, they might consider selling their positions.
VWAP and Simple Moving Average (SMA): Which is Better?
The Simple Moving Average (SMA) and Volume Weighted Average Price (VWAP) are two important technical analysis indicators used for evaluating the average price of security over a specific period. There exists an important difference between the two.
SMA calculates the average price by considering time alone, while VWAP considers both the price and trading volume. As a result, the price of larger trades has a greater impact on VWAP in contrast to SMA. Hence, VWAP is a truer indicator of the average price of a security, particularly while trading a large volume of shares.
What are the Benefits of VWAP?
Being an investor, it is crucial to understand the benefits of using VWAP and why it is frequently used for stock price analysis. Let’s look into the benefits in detail:
- If there are rapid fluctuations in prices in a day, it might confuse a trader. The VWAP indicator solves this problem by providing a fixed value around which a stock is being traded.
- This indicator informs the traders when to enter and exit a stock position during intraday trading.
- Intraday traders prefer using this tool as it is one of the few metrics in the stock market that allows them to accurately determine price trends in a day.
- VWAP provides traders and investors with an idea of momentum during a specific timeframe.
What are the Drawbacks of VWAP?
The VWAP is used daily, and its value is reset each trading day at the very beginning. That is why calculating the VWAP for a few days can give inaccurate values. While investors might prefer purchasing below the VWAP or selling above it, the prices can move unexpectedly. During an uptrend, prices may continue to rise without falling below the VWAP. Thus, traders waiting for the prices to fall might miss out on opportunities.
While VWAP is a useful indicator, it is closely linked with an opening price range of the day. With the progress of each trading day, the lag increases. For instance, calculating VWAP for one minute after 330 minutes of trading might resemble 390 minutes of moving average at the end of a trading day.
Trading Strategy of VWAP
The general rule to follow for using VWAP for trading is to point out the slope of the line. This is the first and foremost strategy to consider while trading with VWAP. Conducting trading solely on VWAP without following other trading tools can lead you to misjudge market sentiments. The main rule to follow with VWAP trading is as follows:
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Moving into a Long Position
While making an entry into a long position, the moving VWAP appears positively sloped while the derivative oscillator remains above zero.
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Moving into a Short Position
Here, the moving VWAP appears negatively sloped with a derivative oscillator lying below zero.
Final Thoughts
VWAP is quite popular among stock traders who use it to monitor prices and trends throughout the trading day. This analysis is done to identify whether a stock is overvalued or undervalued. VWAP is useful, but it is better suited for day traders than for long-term investment decisions.
VWAP, if used properly, improves the execution of trades, lessens the impact on the market, and affords better trading strategies for both institutional and individual investors.
