What is VWAP and how to use it in your trading strategy?

The Volume-Weighted Average Price, or the VWAP, is one of the most popular intraday indicators. When interpreted correctly, it provides information on both the overall trend and the value of a security.

Read on to find out what VWAP is and how you can integrate it into your trading strategy.

What is the volume-weighted average price (VWAP)?

The volume-weighted average price (VWAP) is a technical indicator that represents the average price an asset has traded at during one day based on the price and volume.

The VWAP indicator is often used by fund managers because it helps them buy or sell large amounts of stock without moving the stock’s price too much. This is important because if you’re buying a lot of shares, you don’t want the price to go up before you’re done buying. The same goes for selling.

Consequently, it is believed that using the VWAP reduces transaction costs by minimising market costs.

VWAP is also commonly used in computer-based trading. There are two main ways this is done:

1. Guaranteed VWAP: A broker promises to match the VWAP price when executing an order. The broker uses a computer program to help make this happen.
2. VWAP as a guideline: The broker tries to get the best possible price and then reports back to the customer. The price might not exactly match the VWAP, but the fee for this service is usually lower.

In simple terms, VWAP is a useful tool for traders who want to make smart buying and selling decisions based on both price and trading volume.

Why use the VWAP indicator?

In trading, you generally have three options: buy, sell, or wait. VWAP is a useful tool for helping traders make these decisions more effectively by combining both price and volume.

The goal in trading is to buy at a low price and sell at a high price. However, knowing exactly when a price is low or high can be challenging. That’s where VWAP comes in. It provides traders with information that can help them identify better entry and exit points based on the day’s trading activity.

Unlike some other indicators, VWAP offers a real-time snapshot of the market, reflecting all transactions up to the current moment. This helps traders get a comprehensive understanding of market conditions.

It’s important to note that while VWAP is useful, it’s not a standalone tool for assessing the overall risk of trading a particular asset. Traders often use it in combination with other indicators to make well-informed decisions.

Lastly, although VWAP can provide some insights into market conditions, it’s not commonly used to determine if the market is overbought or oversold. For that purpose, traders usually turn to other indicators like the Relative Strength Index (RSI).

What is the formula for the VWAP indicator?

Here is how the VWAP indicator is calculated:

• For each time period you’re looking at (like one minute, five minutes, etc.), multiply the closing price of the asset by the volume of trades that happened in that time period.

Price x Volume=Value for that period

• Add up all these values for each time period from the start of the trading day until the current time.

Total Value=Value for first period+Value for second period+…+Value for last period

Similarly, add up the total volume of trades for each time period from the start of the trading day until now.

Total Volume=Volume for first period+Volume for second period+…+Volume for last period

Divide the total value by the total volume:

Trading strategies with the VWAP indicator

The VWAP is a commonly used trading tool, and its popularity can sometimes make it act like a self-fulfilling prophecy. For instance, if a stock is trading below its VWAP but showing an upward trend, traders may anticipate that the stock will move toward the VWAP. As more traders buy the stock with this expectation, the stock’s price might naturally rise to meet the VWAP.

Conversely, traders who expect a stock’s price to go down (“bearish” traders) might place orders to sell the stock short at the VWAP. They expect that other traders will also want to sell, causing the stock’s price to fall.

The VWAP is most effective when used in combination with other trading indicators or a broader trading strategy. Financial markets move quickly, so it’s important to analyse stock movements from multiple angles.

Strategy 1: Using VWAP as support/resistance

One straightforward way to use the VWAP is as a gauge of support and resistance levels. When a stock’s price is above the VWAP, the VWAP can act as a support level. When the stock’s price is below the VWAP, it can act as a resistance level.

The direction of the VWAP line can also be seen as an indicator of the stock’s overall trend, serving as a basic trend line.

Strategy 2: Using VWAP as entry and exit levels

The VWAP can serve different purposes depending on a trader’s position. For instance, if you already own a stock and it’s trading below the VWAP, you could consider the VWAP as a target for exiting your position. If you’re looking to buy, you could wait for the stock price to rise above the VWAP or to rebound off the VWAP during a pullback. The VWAP, along with its upper and lower bands, can help you find good entry and exit points.

Strategy 3: Using VWAP to measure relative strength

If an asset is trading above its VWAP, that’s generally a bullish sign. Conversely, an asset trading below its VWAP is often bearish. A quick look at the VWAP can give you a sense of the asset’s relative strength or weakness. This information becomes even more valuable when compared to broader market indices and similar assets.

For example, short-selling a stock that is trending upward and trading above its VWAP could expose you to a “short squeeze,” where you’re betting against the trend. On the other hand, shorting a stock that is in a downtrend and below its VWAP is generally a lower-risk move, as it aligns with the prevailing weakness.

Strategy 4: Trading with a ‘crossed’ VWAP

When an asset price crosses above the VWAP, it could signal a potential upward breakout, prompting a decision to buy. Similarly, if the stock price crosses below the VWAP, that could be a signal to sell. The VWAP can also serve as a “stop zone,” a price level where you might decide to exit a position to limit losses.

VWAP in institutional trading

Institutional investors and fund managers often use VWAP to assess the effectiveness of their trading. If they consistently execute orders above the VWAP, it may prompt them to find other ways or partners to improve trading efficiency. VWAP also helps these large investors measure the market impact and liquidity of their trades.

Unconsidered execution of large orders can cause stock prices to spike, followed by a sharp decline. This is why institutions often rely on VWAP to mitigate such impact. VWAP is most effective when used in combination with other indicators like the MACD or the stochastic oscillator.

How to use VWAP in Metatrader 4/5?

VWAP is commonly available on trading platforms like MetaTrader 4 and MetaTrader 5. While it’s predominantly used for stock trading, it’s becoming more relevant in forex markets, particularly for short-term trading.

Let’s say we wanted to analyse the EUR/USD pair in the last few hours to decide whether to execute a trade 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.

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 to 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 based on price and time, and each price receives an equal weighting in the calculation of the average.

VWAP can be a more accurate indicator than a simple moving average, as it reflects the actual price. In technical analysis, volume remains a variable that tends to be very important in confirming trends, trend changes, supports, resistances, breakouts and others. Since 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 as easily available, given the decentralised 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 criticise 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, although some still prefer to use tick volume.

How to use the VWAP indicator?

It may also apply to long-term strategies

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. However, it is not suitable for medium and long-term investment strategies.

Some traders use a moving average of VWAP, known as MVWAP, to gain a more comprehensive understanding of long-term trends. This is a moving volume-weighted average price indicator that has no final value (it runs from one day to the next).

VWAP in short-term trading

The first thing you may want to do 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.

Possible VWAP configuration

1. Double-click the VWAP indicator on the trading platform MT5.
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.

You may want to look 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 the support levels. Then, wait for the candle to close above both and enter during a pullback.

Is the VWAP indicator reliable?

VWAP is widely used and can be reliable, but it’s best when used in conjunction with other indicators. It’s a popular tool among both retail and institutional traders, although it is primarily used for intraday trading.

However, since it is a summarised version of a single day, the VWAP indicator has little meaning when making predictions.

If you are interested in intraday trading, this indicator may be quite helpful. Have a look at the best brokers for intraday trading to get started.

Which indicators work best in combination with the VWAP?

For intraday trading, these indicators complement VWAP well:

1. RSI (Relative Strength Index): Helps identify overbought or oversold conditions, which can signal potential reversals in price.
2. Bollinger Bands: This tool can help to identify volatility and price levels that are significantly higher or lower than the average. When used with VWAP, it can provide more confidence in your entry and exit points.
3. MACD (Moving Average Convergence Divergence): A trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. It can be used to confirm trends and potential buy/sell signals.
4. Fibonacci Retracement: This tool identifies potential support and resistance levels based on a set of horizontal lines that display where a strong price movement could potentially retrace.

Summary

To conclude, we’ve discussed the key aspects of the VWAP indicator, examining how it’s calculated and used in trading strategies. This indicator can be a key variable for intraday trading strategies, but can also be modified to suit a long-term perspective by using the MVWAP instead. Nonetheless, it is important to use other indicators to complement your analysis before making a decision.

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