Volume Weighted Average Price (VWAP) is an indicator, or an intra-day calculation that is used to determine where a stock is trading relative to it’s volume weighted average for the day. For the matheletes out there, the equation is below. It also helps to determine market direction and confirm trade signals. Before you apply the indicator to your charts, understand how it works, the drawbacks of the indicator, and how to read the signals it gives you.VWAP equation

As many as the last four daily VWAPs can be plotted by the indicator on the current session of the analyzed security. At times, the older VWAPs can serve as support and resistance lines as the current session’s price action develops, and can potentially offer valuable information for traders. The (default) intraday VWAP is reset at the beginning of each new trading session. Most trading applications only show the current day’s VWAP. This is mainly because historical VWAPs require enormous amounts of data, since all the tick and volume data for the different sessions would need to be referenced.

In a steady uptrend or downtrend, price will still continue to touch the indicator line at several points along the way. Price may drift away, only to be pulled back toward it again. Only in strong up or down moves will you see price extend further from the indicator. This is yet another way of using the indicator,  to determine the strength of moves based on their distance from the indicator.




VWAP vs. Moving Averages

VWAP initiates at the opening price level, and will move up or down with price movement and volume as the session continues. It can help to eliminate a lot of the noise within a stock throughout the day, even more so than a moving average would. It is compared at times to a moving average, and though it shares similarities, they are not the same.

The biggest difference VWAP has from a moving average is the overall time frame. Moving averages are made to average specific amounts of time (9 candles, 50 candles, 200, etc.) VWAP however, is an average of the entire day. The closer to the open, the more sensitive the indicator is to price moves. As the day goes on, it becomes less so. This is a result of cumulative values, so as volume increases toward the end of the day, every piece of new data has less and less effect on VWAP.

AAPL VWAP 2

Trading with VWAP

It is said that when price is below VWAP, the stock is in a downtrend or there is a downward bias to the day. The opposite is true if above. The indicator itself is more of an analysis tool rather than an entry/exit indicator. However, as a result of this association, the indicator is often traded like a moving average. Price will commonly either bounce and reverse direction, or break directly through. If you choose to treat VWAP as a moving average entry/exit signal indicator, the following would be potential entry points:

Long Entry – A (convincing) break to upside

Long Exit – A (convincing) break to downside

Short Entry – A (convincing) break to downside

Short Exit – A (convincing) break to upside

If you choose to use this method, I recommend monitoring 5 min charts to confirm VWAP breaks. As you can see in the previous 1 min chart above, at several points price breaks above or below VWAP, only to then reverse and retrace. 5 min charts provide more reliable confirmation of breaks and entry/exit signals. In realtime, wait for candles to close before confirming breaks. These are demonstrated on the same $AAPL session on a 5 min chart below:

VWAP

Despite what you see above, the best entry signals are formed using VWAP in tandem with other set ups and/or indicators. An example of this would be a BARR pattern that is extended high above VWAP. The break of the bump line would be your short entry signal within the pattern.

Using the same 1 min chart for $AAPL, an example is provided below. In this scenario, notice that we are looking at a BARR pattern late in the day. High above VWAP, once the BUMP line breaks we have further confirmation that price will continue down, creating a less risk short entry scenario. As a third confirmation, RSI is overbought. Even further, 1 minute/candle later a MACD death cross is created as a fourth confirmation.

AAPL BARR

On days that price action is trending, price will be above or below VWAP for much of the day. On ranging days that price action is consolidating or coiling, VWAP will flow through the middle of price action, showing the overall sideways direction of trading. This can help traders determine what type of strategy they should be utilizing.

VWAP Limitations

VWAP is tricky. It’s a debatable indicator, in that it is used in numerous ways and calculated differently in certain scenarios as well. Some traders believe VWAP should include pre-market and after hours data. Others think VWAP should not include in this information. Some even plot both forms (one with and one w/o PM and AH data) on their charts. This is where experimentation is necessary on your end. Personally, I prefer the 1 min intraday VWAP with pre-market and after hour data included.

The difference from a moving average, which is commonly used in the development of trading strategies, is that VWAP is more of an analysis tool than a trade signal tool, as mentioned before. It gives a basic directional guide for whether there’s an upward or downward bias in price action, but the actual line alone shouldn’t be used to provide consistently good trade signals. A good reason could be that during strong trending moves the price may not touch (or even come close to) the VWAP.

As mentioned before, the indicator is less sensitive to price action as the day extends. Later in the day, the “lag” can become significant. Therefore, VWAP is of more value at the start of day to traders (in a directional sense) because it is more responsive to price moves. On the flip side, at the end of the day the indicator will flatten out and be of little use to traders (harder to determine overall up/down movement.) However, to major institutions, the end of day VWAP values are more important, since the end of the day VWAP value gives a benchmark for the day that the institution can compare their transactions.

Conclusion

This indicator is meant to give the average price of a stock (so far) for the trading day, based on price moves and volume. It’s an intra-day indicator, starting with the first period (based on chart time frame chosen) of the day, and ending with the last. The larger the time frame of candles, the less useful the indicator becomes.

Although many traders rely on VWAP for their entries, it isn’t really meant to provide trade signals like other indicators; it’s an benchmarking and analysis tool. Used in tandem with other indications, it can be very useful and effective.

If you learned something useful here, share it with others. Godspeed traders.

Volume Weighted Average Price (VWAP)

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