Volume-Weighted Average Price (VWAP) Indicator – Trading Strategy and Tips

The Volume-weighted Average Price (VWAP) is a technical analysis indicator that measures the average share price of an asset in relation to its trading volume. It serves as a versatile tool for traders and institutions to make informed trading decisions.

In this guide, we will cover everything you need to know about the VWAP indicator, including how to use the indicator and implement the VWAP trading strategy. 

What is the Volume-weighted Average Price (VWAP) Indicator?

The VWAP technical indicator is a benchmark that gauges the relationship between an asset’s average price and the total volume traded over a specific time frame. 

It helps answer a fundamental question: Is the current price overpriced or underpriced compared to the average price for the day? Armed with this knowledge, market participants can make informed decisions about entering or exiting positions.

So, how does VWAP assist traders and investors? It helps answer a fundamental question: Is the current price overpriced or underpriced compared to the average price for the day? Armed with this knowledge, market participants can make informed decisions about entering or exiting positions.

The VWAP also serves as a benchmark for executing large order blocks. Imagine a portfolio manager looking to acquire thousands of shares while aiming to do so at a price below the average for the day. The VWAP becomes their target.

Success for such a trader is determined by comparing the average purchase price to the VWAP at the time of accumulation. VWAP is, therefore, commonly used by large institutions, hedge funds, and even central banks and governments.

Now that we have covered the importance of VWAP, let’s explore how it’s calculated. VWAP is computed using intraday price movement, with adjustments occurring continuously until the session’s close.

The Formula for VWAP Calculation

The process starts with the Typical Price (TP) of the first completed bar or candle on the chart. Keep in mind that this price depends on the chart’s time frame you’re observing. For example, on a fifteen-minute chart, it would be the Typical Price of the first fifteen-minute bar or candle.

What sets VWAP apart is its real-time adjustments. As the trading day unfolds, VWAP adapts to incorporate the changing Typical Price and Volume. This real-time nature ensures that VWAP remains a relevant and dynamic tool for traders throughout the trading session.

How to Use the Volume-Weighted Average Price (VWAP) Indicator in Trading

One of the primary ways traders use VWAP is as a trend confirmation tool. Essentially, it helps traders define the trend and construct trading rules around it. Here’s how it works:

Traders often consider stocks or other financial assets trading below the VWAP line as potentially undervalued, while those trading above it might be seen as overvalued. This simple yet effective metric allows traders to quickly gauge the relative pricing of a stock compared to its historical average for the day.

For example, when the price of a stock that was previously below the VWAP line suddenly crosses above it, this can be seen as a signal to go long on the stock. Conversely, if a stock’s price, which was above the VWAP line, dips below it, it may trigger actions such as selling positions or even initiating short positions.

Another reason to use VWAP is due to the extensive of the indicator by large market participants. As mentioned, institutional traders, such as mutual funds, use VWAP as a tool to execute their trades with precision while minimizing market impact.

These ‘big players’ recognize the importance of buying below the VWAP line and selling above it. By doing so, they aim to align their trades with the prevailing market sentiment, ensuring that their actions contribute to pushing the price action back toward the VWAP average, rather than creating wild fluctuations.

These institutions often handle large volumes of shares, and executing such trades can significantly influence a stock’s price. Using VWAP, they aim to reduce this market impact, making their moves as hidden as possible. This approach helps maintain market stability and prevents sharp price swings.

Therefore, based on the Smart Money Concept strategy, the VWAP is a strong indicator for retail traders to predict future price movements.

Volume-weighted Average Price Indicator Trading Strategy

There are various ways to trade the VWAP. For example, some traders use the VWAP without any additional trading indicator, relying solely on its signals to enter and exit positions. Of course, you can do that. However, to increase the chances of success, you better add another indicator as a confluence trading tool.

So, here’s a simple trading strategy involving the Volume-Weighted Average Price (VWAP).

Entry Rules

The first thing you want to do is to scout for buying opportunities when the price is above the VWAP line. Conversely, your selling opportunities will come when the price is below the VWAP line. It is important to not take a trade that goes against the bias of the VWAP.

Next, pull up any other indicator to pin down your trade entries. In our example, we’re using the Relative Strength Index (RSI) indicator, but you could use the MACD or any other indicator that you prefer. The idea is to get any indicator a little more fast-paced to take your entries on.

For a valid long trade entry:

• Wait for a bullish bias of the VWAP line. When the line is below the price, that means your bias is bullish.
• Wait for a bullish crossover of the two oscillating RSI lines. The crossover must happen below the 50-level of the RSI.

When those two happen, you have a clean buy trade in your hands. Pull the trigger.

And for a valid short entry:

• You want to see a bearish bias of the VWAP, where the price is below the line of the indicator.
• The RSI must give you a bearish crossover from above its 50-level.

The image below is the chart of the AAPL stock. Notice how the first bullish crossover happens below the 50-level. And at that same instance, the price rises above the VWAP line. The close of that candlestick is your entry. Normally, that is the only entry you need.

But notice that the signal repeats itself not long after the first signal. The RSI gives us another bullish crossover from below the 50-level just as the price is breaking above the VWAP line once again. That is another bullish trade entry opportunity for you to take.

Now, you don’t need to take both trades. You don’t have to even wait for the second one to form. The first trade opportunity that comes is the first one you take. But we’re leaving both opportunities on the chart just to remind you of how you would enter the trade.

Exit Rules

Place your stop loss just below the most recent swing low (for long positions) or above the most recent swing high (for short positions). As the trade moves in your favor, consider trailing your stop loss to lock in profits.

You can also set a reasonable profit target based on support/resistance levels or previous price swings.

Volume-Weighted Average Price (VWAP) Indicator – Pros and Cons

Here are some of the advantages and limitations of the Volume-Weighted Average Price (VWAP) Indicator:

Benefits of Using the Volume-weighted Average Price Indicator

VWAP is exceptionally effective in depicting the relationship between a stock’s price and its trading volume. It provides traders with a clear and easily interpretable snapshot of market dynamics. Many institutional buyers, such as mutual funds, rely on VWAP to minimize market impact when executing large trades. This institutional adoption adds to its credibility as a valuable tool.

Limitations of the Volume-weighted Average Price Indicator

VWAP is a single-day indicator, resetting at the open of each new trading day. Attempting to create an average VWAP over multiple days could distort its accuracy, leading to incorrect readings. While some traders may prefer buying below VWAP and selling above it, VWAP should not be the sole factor driving trading decisions. In strong uptrends, stock prices can continue to surge without dropping below VWAP. Waiting for such a drop might result in missed opportunities during rapid price increases.

Key Takeaways

Frequently Asked Questions about the VWAP Indicator

Here are some frequently asked questions on the VWAP trading strategy:

What is the significance of VWAP?

VWAP, short for volume-weighted average price, serves as a crucial technical analysis tool, especially for those who utilize the scalping trading strategy. It reveals the relationship between an asset’s price and its total trading volume, providing traders and investors with an average trading price over a specific time frame.

Which complementary indicators can enhance VWAP’s effectiveness?

To get more accurate trading signals, traders often combine VWAP with other technical indicators. Examples include using VWAP with moving averages, such as simple moving averages (SMAs) or exponential moving averages (EMAs). This combination helps identify crossovers, which can signal potential shifts in trends or their continuations.

How does VWAP influence day trading strategies?

VWAP holds significant importance in day trading. It enables traders and analysts to filter out the intraday noise, offering a clearer picture of the actual prices at which buyers and sellers are executing trades in the stock or market. VWAP provides valuable insights into daily stock trading patterns and aids in determining favorable buying or selling prices for some traders.

What sets VWAP apart from Bollinger Bands?

VWAP and Bollinger Bands are distinct indicators with different methodologies. VWAP is calculated based on price and volume data over a user-defined period, reflecting average trading prices. In contrast, Bollinger Bands, developed by John Bollinger, are plotted on charts using standard deviation calculated from the average price. These bands help identify price volatility and potential price extremes.