How to Use the VWAP Indicator to Make Better Trading Decisions

When we talk about trading and technical analysis, one of the most used indicators by professionals is the VWAP due to the high information it provides in terms of market liquidity.

But, what is the VWAP indicator? How is it used? and above all, with what strategies can it be combined? In this post, we'll give you all the keys to one of the favorite indicators of financial gurus.

What is VWAP indicator?

What is VWAP (pronounced VIWAP)?

In finance, the volume-weighted average price (VWAP) is the ratio between the value of a financial asset traded and the total volume of transactions during a trading session. It is a measure of the average trading price of that specific period.

Normally, the indicator is calculated for one day, but it can be measured between two different moments.

VWAP –Volume-weighted average price– is often used as a trading reference by investors who want to be as passive as possible in their execution. Many pension funds and some investment funds fall into this category. The goal of using a VWAP trading target is to ensure that the operator executing the order does so in line with the market volume.

It is sometimes argued that such execution reduces transaction costs by minimizing market impact costs (the additional cost due to market impact, i.e. the adverse effect of an operator's activities on the price of a security).

VWAP is often used in algorithmic trading. A good broker can guarantee the execution of an order to VWAP and have a computer program enter orders into the market to earn the operator's commission and create P&L (“Profit and loss”). This is called guaranteed VWAP execution.

The broker can also trade in the best possible way and respond to the customer with the realized price. This is called objective VWAP execution; it incurs greater dispersion in the price responded compared to the VWAP price for the customer, but a lower commission received/paid. Trading algorithms that use VWAP as a target belongs to a class of algorithms known as volume participation algorithms.

Digesting all this is quite complex, so we are going to try to explain it so that the common mortals can assimilate it easily.

In short, VWAP is a tool used by trading professionals, to make decisions more efficiently.

👉 More information about other indicators in the following article: Main trading indicators.

Why Use the VWAP Indicator?

In very basic terms, there are three things you can do when trading: Sell, buy, or wait.

The derivatives that come from VWAP are useful for combining price and volume to make the most beneficial decision. That is, decide whether to sell, buy, or wait.

We all understand logically that the most appropriate strategy is to buy cheap and sell expensive, right? The difficulty lies in knowing for sure when a value is expensive or cheap. Therefore, the main reason for using VWAP is that it provides us with certain information to act with sufficient guarantees of success.

Now let's see how VWAP can help us effectively manage real risk. VWAP is real information coming from the market during that exercise. It is understood that it is based on approximately 70% (68.27%) of all transactions occurring up to that particular moment.

When we find the price with the highest number of transactions -thick trading-, then we can decide if the market is overbought or oversold compared to its current price and the average.

What is the formula for the VWAP indicator?

The VWAP is calculated (automatically) by taking the average of the maximum, minimum, and closing of the time period and then weighting that average price by the total volume traded in that period. As the day progresses, it is necessary to keep updating the formula for each time period to obtain the VWAP line throughout the day.

VWAP Formula

Trading Strategies with the VWAP Indicator

Since VWAP is such a popular tool used by traders, it can often have self-fulfilling prophecy characteristics. If a stock is trading up but still below VWAP, traders can anticipate the VWAP test and enter a long position directed towards VWAP. As traders jump on board trying to get ahead of the next trader, the stock can naturally rise towards VWAP.

On the other hand, “bears” waiting for rejection at VWAP can place their limit orders to short the stock at VWAP, expecting there to be profit takers and more sellers.

VWAP is more useful when combined with other indicators or a trading methodology.

We must remember that today's financial markets move so quickly that they must be analyzed from different perspectives.

Strategy 1: Using VWAP as Support/Resistance

One of the simplest uses of VWAP is to gauge support and/or resistance. It is a simple line (VWAP) that acts as support if the stock is trading above it and as resistance if the stock is trading below. The direction of the VWAP line is the indication of the trend, so it is used as a “de facto” trend line.

VWAP Support and Resistance Strategy

Strategy 2: Using VWAP as Entry and Exit Levels

One trader's support is another trader's resistance. In other words, a trader who has a long position can use VWAP as an exit target if it trades below. Traders looking to take a long position can wait for the stock to break through VWAP for longs or pullback and bounce off VWAP on pullbacks. VWAP is a good entry and exit zone. If it also has the upper and lower envelopes accompanying it, these can be used to re-enter VWAP.

Bounce Off Strategy of VWAP

Strategy 3: Use VWAP to Measure Relative Strength

A stock trading above its intraday VWAP can be bullish, while a stock trading below can be bearish. A quick glance at the chart gives you an immediate indicator of relative strength or weakness. When combined with readings of the benchmark indices and related stocks' VWAPs, you can compare and calibrate whether the stock is showing relative strength or weakness. It also allows you to think more deeply about your trade.

For example, shorting a stock that is in an uptrend and trading above its VWAP makes it susceptible to a “short squeeze”, as you are trading against the trend. Conversely, shorting a stock in a downtrend and trading below its VWAP allows you to trade with the relative weakness aligned with the trend.

Measuring Relative Strength with VWAP

Strategy 4: Trading with a ‘Crossed’ VWAP

When the price of the underlying stock crosses the VWAP from below, it can represent a breakout. This can be a signal to go long on the stock. If a stock falls below the VWAP, it could be a short-term sell signal as it breaks. The VWAP is also a good stop zone if support is broken. For example, you can plan to enter XYZ on a breakout through 27.10 Euros, which is the VWAP, and place a trailing stop of 0.20 Euros below the VWAP. This allows you to design a quantifiable “action plan” for your trade. Remember that the VWAP works best when combined with complementary indicators, especially with momentum (momentum indicators).

Used by Institutions

Institutions and fund managers can use the VWAP to measure the quality of their orders. If orders are consistently executed above the VWAP, the manager may look for other market makers or traders to execute the orders.

Institutions may want to enter a position, but the price at which they enter can have an impact on the market. The VWAP is also used to measure the liquidity and market impact of institutional orders.

If the trader executes orders recklessly, the stocks will rise, triggering a chasing element of executions and a possible sharp drop once the orders have been executed.

There are many ways to trade with the VWAP. Again, it works best when combined with other complementary indicators, including momentum indicators such as the MACD or the stochastic (stochastic)

How to Use VWAP in Metatrader 4/5?

The VWAP (Volume Weighted Average Price) is an advanced technical indicator available for free on the MetaTrader 4 or MT5 trading platforms. It is plotted directly on the chart for an easy-to-read visual representation of complex mathematics.

Forex trading strategies have also started to incorporate the MQL4 VWAP indicator in their analysis. I must emphasize that it is more effective for intraday trading in Forex. Long-term strategies do not benefit as much from what the VWAP indicator indicates.

Let's imagine that we wanted to analyze the price of the EUR/USD currencies in the last few hours to decide whether to execute a transaction or not.

What we would do is open a simple moving average indicator on the hourly chart and configure it to calculate a simple average of the last five closing prices per hour.

Say the closing prices had been: 1.1000, 1.1010, 1.1020, 1.1030, and 1.1040, the indicator would show the average price as 1.1020 (the sum of each of the five values, divided by five).

Now let's compare that with the VWAP applied to the same asset and configuration. The VWAP will read the volume data showing how much EUR/USD was bought at each of the five prices and give greater weight to the prices at which more volume was traded.

For example, almost all the volume, during that time, was traded at 1.1000. Then the VWAP will show an average price very close to 1.1000, much lower than the price shown by the simple moving average, which is only interested in the price and time, and each price receives an equal weighting in the calculation of the average.

The VWAP provides a more accurate indicator, as it reflects the actual price. In technical analysis, volume remains a variable that tends to be very important to confirm trends, trend changes, supports, resistances, breakouts, and breakdowns. Since the VWAP uses it in its formula, it is more reliable and useful than moving average indicators.

The VWAP indicator is more popular among equity traders because volume data for stocks is available with each transaction, and many online resources provide end-of-day volume data for free.

In the foreign exchange market, volume is more complex and is not usually so easily available, given the decentralized nature of foreign exchange trading.

This can make VWAP more difficult to apply in the foreign exchange market, although some Forex traders believe they have found a way to avoid it by using tick volume instead of real volume data as volume input.
Although some analysts criticize this practice, there are studies showing a positive correlation between real volume and tick volume in the foreign exchange market. More and more Forex brokers are making their own real volume data available to their clients, so sometimes the indicator can be connected to them, although some still prefer to use tick volume.

Breaking the VWAP usually “gives” a lot of volume.

How to Use the VWAP Indicator?

The rise of algorithmic trading and the popularity of short-term strategies made the VMAP indicator one of the most popular technical indicators among retail traders. It is not very suitable for medium and long-term trading strategies, but there are two formulas for using it in higher time frames:

VWAP can suggest good entry and exit levels by confirming support and resistance levels. Basically, when VWAP shows unusually high volume, it is likely to become a good support or resistance level. I recommend using other technical analysis tools to identify the medium or long-term trend in itself.

Using a moving average of the VWAP, also known as MVMAP, provides a moving average of a moving average and can offer medium and long-term traders a “better understanding” -of real value- than a simple VWAP.

VWAP in Short-Term Trading

The first thing I recommend is to adjust the VWAP indicator settings. The default setting shows the daily, weekly, and monthly VWAP. Since we are going to trade the VWAP in the short term, those time frames are not suitable.
We will use the MT5 platform as an example below since the VWAP is more popular among MT5 users than MT4:

However, before you start investing in such a short term, I recommend that you read this article on the extreme discipline required in volume trading.

Possible VWAP Configuration

  1. Double-click the VWAP indicator on the MT5 trading platform.
  2. Double-click “Enable_Level_01 false”. It will change to true.
  3. The default value for the short period is 5 time periods.
  4. Double-click “Enable_Level_02 false”. It will change to true.
  5. The default value for the long period is 13 time periods. Adjust to the desired time frame.
  6. Click OK.

Since the VWAP works like moving averages, it is effective in finding crossovers and trading with the trend. More precise trading signals can also be found when used in conjunction with the daily VWAP as a multiple-time frame analysis.

I recommend looking for long entry signals when the VWAP X (first value) crosses above the VWAP Y (second reference value) if the price action is bouncing off support levels. I wait for the candle to close above both and enter during a pullback. Or on a breakout above the daily VWAP after the VWAP X crosses above the VWAP Y.

Is the VWAP Indicator Reliable?

Yes, but with caution. It actually depends. It is a relative indicator and as we have repeated here, it is necessary to combine it with other indicators to be better informed when making the relevant decision.

In the 10K reports of Goldman Sachs or JP Morgan, (which everyone can consult), we can observe that the VWAP appears with assiduity.

The general belief among professional -and non-professional- traders is that a sufficient number of institutional traders use the VWAP as a reference. Traders usually believe that the recognition of this dynamic should be included in the trading strategy (trading).

But since it is a one-day summary version, the VWAP has no real effect when making predictions or calculations for the future, except in the case of “assumptions”.

Our recommendation from Rankia is to use it with other indicators. You know, security first.

In any case, if you are going to start trading in the short term, I recommend reading this article where you can find the best trading platforms, so that in your technical analysis you can combine the VWAP indicator, with any other.

Which Indicators Work Best In Combination With VWAP?

The 7 indicators that we suggest from Rankia, for intraday trading:

  • VWAP (Volume Weighted Average Price)
  • EMA (Exponential Moving Average)
  • Supertrend Indicator.
  • ADX (Average Directional Index)
  • OBV (On Balance Volume)
  • Donchian Channel.
  • CPR (Central Pivot Range)

And as always now it's your turn. Do you usually use the VWAP indicator? What strategy do you apply to it? and What other indicator do you combine it with? I'll read your comments.

FAQs

How can I use the VWAP indicator to trade?

The VWAP indicator can be used in a variety of ways to trade. For example, you can use it to identify support and resistance levels, to set stop-losses and profit targets, and to confirm trading signals from other indicators. You can also use it to measure the liquidity of a security.

What are the best settings for the VWAP indicator?

The best settings for the VWAP indicator will vary depending on the security you are trading and your trading style. However, a common setting is to use a period of 10 days.


What are the limitations of using the VWAP indicator?

The VWAP indicator can be slow to react to changes in price, and it can be affected by gaps in the market. It is also important to note that the VWAP indicator is not a perfect indicator, and it should not be used as the sole basis for making trading decisions.

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