Technical indicators are an essential part of analyzing the financial markets. Some of them aim to illustrate momentum while others may be used to find potential points of interest on a chart. But the most fundamental indicator out there is arguably volume. Volume can be used as a tool for confirming a trend, identifying potential points of reversal, and many other strategies.
The VWAP combines the power of volume with price action to create a practical and easy-to-use indicator. Traders may use the VWAP as a tool for trend confirmation, or as an instrument to identify entry and exit points. Let’s dive into what the VWAP is, its formula, and how to use VWAP so that traders like yourself could possibly incorporate it into your trading strategy.
What is the VWAP?
VWAP stands for the volume-weighted average price. As the name would suggest, it’s the average price of the asset for a given period weighted by volume.
What makes the VWAP a particularly powerful indicator is how it incorporates volume into the average price calculation. Some traders think that volume is the most important metric out there – outside of the price action itself. What makes the VWAP an especially useful tool for both analysts and traders is how it combines these two important metrics into one indicator.
The VWAP can give an indication of the dominant market trend, as well as important areas of liquidity.
VWAP Formula
On most trading interfaces, you can just select the indicator, and the calculations will be done for you. Regardless, it could be helpful to know the formula behind it so you can use it more efficiently. So, how is the VWAP calculated?
To calculate the VWAP, we need to add up the traded value for each transaction (price multiplied by volume), then divide that by the total volume.
VWAP = ∑ (Typical Price * Volume ) / ∑ Volume
where
Typical Price = (High + Low + Close) / 3
Let’s calculate the 5-minute VWAP line for an asset. Here’s what we need to do:
1. First, we need to calculate the typical price for the first 5-minute candlestick. We add the High, Low, Close, and divide that number by 3.
2. We multiply the typical price with the volume for that period (5 minutes, in this case). Let’s call this value n1, as it relates to the first measured period.
3. We divide n1 by the total trading volume up until that period. This gives us the VWAP value for the first 5 minutes of trading.
4. To calculate the successive VWAP values, we need to continue adding the new n values (n2, n3, n4…) from each period to the prior values. Then, we need to divide that by the total volume up until that point.
Now we understand why the VWAP is called a cumulative indicator, as the values are increasing by successive additions.
How to Use VWAP
For those interested in a more passive, longer-term investment style, the VWAP may be used as a benchmark for the current market outlook. A simple strategy might be only to buy assets that are below their VWAP line, indicating that they’re potentially undervalued.
With that said, some traders may use the price crossing the VWAP line as a signal to enter a trade. If the price breaches and goes above the VWAP, they may get into a long position. Conversely, if the price breaches and goes below the VWAP, they may get into a short position.
In this sense, the VWAP may be used similarly to moving averages. When the price is above the VWAP line, the market may be interpreted as bullish. At the same time, if it’s below the VWAP line, the market may be bearish. This, of course, highly depends on the context of the technical pattern and should be taken with caution.
The VWAP may also be used to identify areas of liquidity. This can be especially useful for institutional traders looking to fill large orders. The indicator helps them determine ideal entry and exit points for large trades, which may decrease their market impact.
VWAP Limitations
The VWAP is mostly useful as a single-day indicator. Trying to create a VWAP over multiple days could mean that the average is distorted. As such, the VWAP works best for intraday analysis, that is, an analysis that considers one trading day or less.
Like moving averages, the VWAP is a lagging indicator, as it’s based on past price data. Similarly to a moving average, the more data there is, the greater the lag. As such, a 20-minute VWAP will react more quickly to current price movements than a 200-minute VWAP.
It’s important to keep in mind that since it’s based on past price data, the VWAP doesn’t have any predictive qualities.
While the VWAP is a powerful indicator used by many traders, it’s not to be interpreted in isolation. For example, we’ve discussed that an asset may be considered undervalued when the price is below the VWAP line. However, in a strong uptrend, the price may not go below the VWAP for a considerable amount of time.
As such, traders who are waiting for this specific signal might get left on the sideline and miss out on a potential opportunity. With that said, missing out on a trade may not be the end of the world. If a trader’s entry strategy dictates a specific event happening, and that event doesn’t happen, they shouldn’t enter a trade. However, if their strategy is well-thought-out and they’re consistently sticking to it, they should be doing well over the long-run. Regardless of the approach, it’s crucial to understand and manage the risks.
Closing Thoughts
In summary, the VWAP is an indicator that tells traders what the average price of an asset is for a given period, relative to volume. And how to use VWAP? Some traders may use the VWAP to enter or exit positions based on it crossing with the price. It can be especially useful in helping to identify potential entry and exit points for large trades.
The VWAP is a lagging indicator, meaning it has no predictive qualities for price. Some traders argue it’s at its best when used for intraday analysis. As with any other market analysis tool, the VWAP shouldn’t be interpreted in isolation and works best when combined with other techniques.
