Stock traders often consult a wide range of metrics to inform their decisions, and guide their strategy. However, the most overlooked of these metrics remains volume, a crucial indicator that delivers tremendous insight.

Volume analysis is a niche area that few analysts consider, but those that recognize its potential understand the value these ignored sets of statistics deliver.

This is important because, at its most fundamental level, technical analysis is about the flow of funds into and out of traded securities. Volume is the prime driver of price shifts, yet individually, it is hardly factored into analytical calculations.

VWAP trading, or the volume-weighted average price approach, is an especially important form of volume analysis to turn to, especially when assessing stocks traded heavily in the market.

Many seasoned analysts consider VWAP trading to be the hallmark of technical analysis, with volume always preceding price as an indicator. In this article, we explore this fundamental approach and its importance in optimizing trade strategy.

What Is Volume-Weighted Average Price (VWAP)?

Volume-Weighted Average Price henceforth referred to as VWAP is a unique trading approach that looks at a stock based on the volume of its trade over a specific period. Usually, this period refers to a single day of the stock changing hands.

Through VWAP trading, analysts can determine the average price a stock was trading at, in a particular timeframe, using the range of its trading volume as a weight for calculation. It thus is an extremely reliable price assessment.

VWAP is a reliable metric to turn to, as a stock undergoes significant price fluctuations throughout the day. Using a volume-weighted average pricing approach, one can get an accurate average price to analyze, in a reliable manner.

How to calculate VWAP

In order to understand what is VWAP trading, it would be prudent to go over the way it is calculated. To determine a stock’s VWAP over a given period, an analyst would need to carry out each of the following steps:

1. Determine the period over which the VWAP is to be calculated. This could range from 15 minutes or an hour to a day or even a week.
2. Record all the price points the stock had been trading at throughout the time period.
3. Record all the trading volume levels the stock was for each of the price points noted in the prior step.
4. Multiply each price of the stock with its corresponding volume, and work out the total sum of these figures.
5. Divide the total sum by the total volume for the time range. This will return the VWAP of the stock.

The formula for VWAP is as follows:

VWAP Trading Strategy Used To Determine The Market Trend

Given the information the VWAP calculation delivers, it is no surprise that many analysts turn to it, in order to determine market trends, over short-term periods of time. Information on these trends can be especially useful in real-time trading.

Normally, traders work out the VWAP of a stock and compare it to its current price on the market, attempting when best to buy or sell it.

If the VWAP exceeds the current price, there is an indication of a short-term bearish trend, pointing to strong selling pressure. If the VWAP is lower than the current price, buying pressure is strong and the trend in the short term is bullish.

Knowing the direction of these short-term trends can help analysts and traders predict price movement and momentum over the short term. With this knowledge, they can determine if the best move is to buy, hold, or sell.

How Is VWAP Used?

VWAP trading has a range of real-world applications in the financial market. Primarily, it is used in the following four domains, discussed below:

• Market analysis

  Because VWAP is a reliable measure of short-term trends, it is often applied when assessing buying or selling pressure across markets, after comparison with current prices.

  This information usually tells analysts whether the wider market is bearish or bullish in the immediate sense, and the direction of the overall momentum.

• Institutional trading

  When large institutional investors are involved in the trade of shares, a commonly used metric they consult is the VWAP.

  This is because they usually deal in large volumes of stock, and so knowing the impact of volume on price is extremely useful in predicting gains or losses.

• Benchmarking

  VWAP represents a reliable average price over a certain period, so it is often seen as a benchmark for market players who identify buy or sell opportunities. Therefore, VWAP is often used to set short-term price targets.

• Algorithmic trading

  For those engaged in algorithmic trading, VWAP is a great measure to incorporate. Algorithms can be set up so trade execution takes place when stock prices hit VWAP levels, to benefit from a precision-based strategy.

The Difference Between VWAP and a Simple Moving Average

Although at a first glance, VWAP and the Simple Moving Average (SMA), may seem like similar tools for calculating averages of stock price, they have a fundamental difference, which changes everything about their core reality.

VWAP and SMA are different because the former incorporates volume into its calculation whereas the latter does not. In effect, SMA treats all price points in a given range as equal, whereas VWAP assigns weight based on volume.

As a result, VWAP is a far more sophisticated measure used by advanced traders, whereas the SMA, as its name suggests is basic and straightforward.

Limitations of VWAP

Despite its sophisticated nature, reliability, and widescale application, it is important to know that VWAP trading is not without its fair share of drawbacks. Some of the most well-known limitations of VWAP are as follows:

• Time sensitivity

  VWAP can differ significantly based on which time of the day it was calculated. This is because volume can change the calculated figure at any time.

  Due to this, VWAP may not be very reliable without being used in conjunction with other benchmarks.

• Applicability limitation

  VWAP would only offer utility in cases where highly liquid stocks are being analyzed with high trade volumes. In the case where a particular stock does not meet these criteria, VWAP would fall severely short in delivering insight.

  For this reason, VWAP is a measure that cannot be universally applied and only offer value for a select group of stocks.

• Inability to predict future VWAP

  VWAP is a great measure to compare real-time prices with VWAP for immediate decisions. However, historical VWAP figures cannot be extrapolated to derive future predictions.

  Trading volume can wildly swing VWAP levels, hence there is no utility for future predictions.

• Unsuitable for long-term horizons

  VWAP is an ideal tool for short-term price assessments but does not bring much to the table for those seeking long-term analytical insight.

• Prone to manipulation

  It is possible for large traders to manipulate VWAP by buying or selling large volumes of stock in a given time period. This puts a question mark on the reliability of the measure, especially when it is used as a benchmark.

VWAP Indicator

Often, the VWAP is used exclusively as an indicator when large, institutional traders are looking to identify entry and exit points on a particular stock.

When used as a VWAP trading indicator, it is most often used to identify support and resistance levels. With the knowledge of buying or selling pressure and trend direction, traders can ascertain support and resistance levels.

For example, on a particular day, whenever the current price of Apple Inc. (AAPL) is below its VWAP, there is resistance, and whenever it is above the calculated VWAP, it is essentially a support level.

This is represented in the trading chart below, where the price of AAPL is depicted in blue, and its VWAP is represented by the red line:

Why Is the Volume-Weighted Average Price Important?

Let’s now take a step back and assess the fundamental importance of VWAP to the financial world.

Determining the fair value of a stock over a specific time has been a puzzle many analysts have attempted to solve. VWAP is the most compelling answer to this age-old conundrum, and it does so by factoring in trade volume.

Prices can swing wildly, from minute to minute, and so calculating a volume-weighted average price is extremely useful in telling market players which direction the momentum is working towards.

When traders realize how to use the VWAP indicator, their trading strategy can become more refined, with the knowledge of trend direction, as well as support and resistance levels. They can determine whether buying or selling pressure is dominant.

Use of VWAP Trading Strategy

In addition to VWAP’s role in determining stock trends and buying or selling pressure, it is often used as the basis to develop a reliable trading strategy. Some of these uses are listed below as follows:

• Determining entry and exit points

  Comparing a stock’s current price to VWAP is a great way to derive buy or sell signals, based on whether buying or selling pressure is currently dominant.

• Confirmation for trend reversal

  Often in trading strategies, VWAP is used in conjunction with other tools to confirm trend reversals. For instance, if support and resistance hint at a trend reversal, VWAP can be used to ascertain this information.

• Identifying support and resistance

  Traders typically employ the VWAP approach to see whether the stock price is currently closer to support or resistance levels. This then assists with buy, sell, or hold decisions.

• Trend identification

  Through VWAP, trading strategies are able to deduce whether a trend is upward or downward, hence giving a detailed insight into momentum.

Conclusion

VWAP trading is a robust approach traders use to build a market strategy. Unlike other tools, VWAP is sophisticated, and insightful, and incorporates one of the most vital and overlooked metrics in its calculation: trade volume.

Volatility is the age-old foe in the world of stocks, and VWAP remarkably addresses this fault. By using volume in a weighted average calculation, it soundly represents a fair value over a specific period and optimizes trade strategies.

Incorporating VWAP into one’s trading toolkit could offer a range of benefits, which include trend determination, guidance for entry and exit points, identifying support or resistance, and a lot more.

FAQs

How to use VWAP for day trading?

Day traders can use VWAP to identify where a stock’s current price lies in relation to its volume-weighted average, and determine whether buying or selling pressure is dominant. This can then act as a buying or selling indicator.

Which trading platforms offer VWAP?

A number of trading platforms offer VWAP to its users. Some of the most well-known are Interactive Brokers, TradeStation, and Thinkorswim.

Is VWAP bullish or bearish?

VWIP, on its own, is neither bullish nor bearish. It is merely a volume-based indicator that can determine whether a stock is currently on a short-term bearish or bullish trend.