The Volume Weighted Average Price (VWAP) as the name suggests, is the average price of a stock weighted by the total weight of volume. The VWAP is used for a specific time frame to calculate the average stock price. Traders use it as a trading benchmark that gives the average price of a security traded throughout the day. It takes into consideration both the volume and the price. As we already mentioned in previous sessions volume is very important for traders since it gives “life” or movement to the stock price. In other words, it is important for traders because they can understand the trend and the value of the specific security.
In order to start using VWAP, it is important to understand how to calculate it and therefore have more correct and accurate measures. The formula for VWAP is the following:
Volume Weighted Average Price=(Typical Price+Volume)/(Cumulative Volume)
The VWAP is calculated for each day, starting when the market is opening and ending when the market is closing. Since it is calculated on a daily basis it uses intraday data. Although putting it on a chart will do all the calculations for you, I will show you how the calculation is done manually.
Calculate the typical price of the stock. Typical price is the average price of the opening price and the closing time for the specific day. Therefore, the typical price will be (High Price of the day+ Low price of the day + Current Price)/3. For instance:
Typical Price = 15.67
Next, you need to calculate the typical price multiplied by the volume. Assume that the volume V=20. The equation will be:
15.67 * 20 = 313.33
You can keep a running total of the volume as they aggregate through the day to give you the cumulative volume. The cumulative volume, in our example, is 78. Therefore, the equation will be:
313.33/78 = 4.017
The results of the calculation are demonstrated on the stock’s chart as a line. As mentioned above, the users of VWAP do not need to do these calculations alone since they are done automatically. The user is only responsible for choosing the desired number of periods to be shown in the results.
The volume-weighted average price is the true average price of the security and it does not affect the closing price. The VWAP, like the moving averages, has a lag due to the fact that is also based on historic data. This is why is more suitable for intraday trading. Investors use VWAP for many reasons starting with the most important one, which can indicate a bullish or bearish market. A bullish market will give an increase to the price of the stock and will make the trend line on the chart to move upwards. Likewise, a bearish market will show the selling pressure on the stock and will make the trend line on the chart move downwards. The second reason that investors love VWAP is that it gives them signals when to buy and when to sell.
Traders that use the VWAP as a technical analysis indicator are not using it to enter a buy position when there is a signal to do so. Instead, they are waiting for the most favorable price to enter a trade. For example, a trader that is looking to enter a buy is not willing to pay more than the stock’s average price. This is why the VWAP line helps traders to buy at a lower price and therefore making more profits when selling the stock.
The same is true for the sell signals. Traders that use the VWAP are looking to identify the highest possible price to enter a sell position so they can benefit more by making bigger profits.
Lastly, the VWAP is a better technical analysis tool than moving averages. What is more surprising is that VWAP is used by pension plans that are trying to find a way to occupy a larger portion of the market. With trading, the most important “detail” to look at is timing. VWAP is doing exactly this, gives them the best timing to enter or exit a trade instead of following the general trend. Another advantage it has is that it can be used for both long and short-term trades while showing a lot about the current and future state of security.
As mentioned above, VWAP is a single-day tool, where it is restarting every day at the opening of the market and finishing at the closing of the market. The fact that VWAP can be used for many days, means the average could become distorted.
While some large institutions, private investors and traders will enter a buy position as soon as the price is below the VWAP or enter a sell position as soon as the price is above the VWAP, can give a deeper meaning than just this. For example, in strong uptrends, the price continues moving upwards for many days without dropping below the VWAP. Therefore, in such an extreme situation waiting for the price to drop below the VWAP can result in missed opportunities.
Moreover, the VWAP takes into consideration historic data and does not inherently have predictable figures or indications. Think about it, because the VWAP is based on the opening price of the day, the indicator increases its lag as the day goes on. This is more visible in the 1-minute chart after 330 minutes (the normal length of a typical trading session) will often resemble a 390-minute moving average at the end of the trading day.
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