How Is VWAP Used?
VWAP is used in different ways by traders. Traders may use VWAP as a trend confirmation tool and build trading rules around it. For instance, they may consider stocks with prices below VWAP as undervalued and those with prices above it, overvalued. If prices below VWAP move above it, traders may go long the stock. If prices above VWAP move below it, they may sell their positions or initiate short positions.
Institutional buyers including mutual funds use VWAP to help move into or out of stocks with as small of a market impact as possible. Therefore, when they can, institutions will try to buy below the VWAP, or sell above it. This way their actions push the price back toward the average, instead of away from it.
VWAP Tip
VWAP’s incorporation of volume is valuable to traders for what it can indicate about the degree of trading activity during short periods of time—whether the competition is taking or exiting positions.
Special Considerations
The Difference Between VWAP and a Simple Moving Average
On a chart, VWAP and a simple moving average (SMA) may look similar. However, these two indicators are calculated differently and represent different results.
VWAP is calculated by multiplying typical price by volume, and the dividing by total volume.
A simple moving average incorporates price but not volume. The SMA is calculated by totaling closing prices over a certain period (say 10 days) and then dividing the total by the number of periods (10).
Limitations of VWAP
VWAP is a single-day indicator and restarts at the open of each new trading day. Attempting to create an average VWAP over many days could distort it and result in an incorrect indicator.
While some institutions may prefer to buy when the price of a security is below the VWAP, or sell when it is above, VWAP is not the only factor to consider. In strong uptrends, the price may continue to move higher for many days without dropping below the VWAP at all or only occasionally. Therefore, waiting for the price to fall below VWAP could mean a missed opportunity if prices are rising quickly.
VWAP is based on historical values and does not inherently have predictive qualities or calculations. VWAP is anchored to the opening price range of the day. Therefore, the indicator increases its lag as the day goes on.
This can be seen in the way a 1-minute period VWAP calculation after 330 minutes (the length of a typical trading session) will often resemble a 390-minute moving average at the end of the trading day.
What Is the Volume-Weighted Average Price (VWAP)?
The volume-weighted average price (VWAP) is a measurement that shows the average price of a security, adjusted for its volume. It is calculated during a specific trading session by taking the total dollar value of trading in the security and dividing it by the volume of trades. The formula for calculating VWAP is cumulative typical price x volume divided by cumulative volume.
Why Is the Volume-Weighted Average Price Important?
VWAP gives traders a smoothed-out indication of a security’s price (adjusted for volume) over time. It is used by institutional traders to ensure that their trades do not move the price of the security they are trying to buy or sell too extremely.
For example, a hedge fund might refrain from submitting a buy order for a price above the security’s VWAP, in order to avoid artificially inflating the price of that security. Likewise, it might avoid submitting orders too far below the VWAP, so that the price is not dragged down by its sale.
Understanding the Volume-Weighted Average Price
VWAP is calculated by totaling the dollars traded for every transaction (price multiplied by the volume) and then dividing by the total shares traded.
VWAP = Cumulative Typical Price x Volume/Cumulative Volume
Where Typical Price = High price + Low price + Closing Price/3
Cumulative = total since the trading session opened.
How to calculate VWAP
By adding the VWAP indicator to a streaming chart, the calculation will be made automatically. However, to calculate the VWAP yourself, follow the steps below.
Assume a 5-minute chart. The calculation is the same regardless of what intraday time frame is used.
- Find the average price the stock traded at over the first 5-minute period of the day. To do this, add the high, low, and close, then divide by three. Multiply this by the volume for that period. Record the result in a spreadsheet, under column PV.
- Divide PV by the volume for that period. This will produce the VWAP.
- To maintain the VWAP throughout the day, continue to add the PV value from each period to the prior values. Divide this total by total volume up to that point.
To make Step 3 easier in a spreadsheet, create columns for cumulative PV and cumulative volume and apply the formula to them.
