What should you know about VWAP?
The last time we discuss how to use COT reports to analyze behaviors of different market’s participants. Another great tool you can use to be a successful trader is the VWAP. In this article, we’ll discover together what is the VWAP and how it can be a powerful tool in a trader’s hand. So, let’s start.
What is the VWAP?
VWAP is the abbreviation of Volume Weighted Average Price. At first look, you can think that VWAP is just a moving average price indicator. But, the VWAP is more than that. A moving average indicator is based only on the closing value of an asset’s price, and it will never give you an accurate information about the true average price. To identify the true average price of a stock, you need factoring volume of transactions for a range of prices. That’s what the VWAP help you to achieve.
How to calculate the VWAP?
The VWAP calculation for an asset is done with the following formula:
Calculation of VWAP consists of five simple steps:
- Based on a price data (OHLC) is calculated a Typical Price [(H+L+C)/3]. As well you can select other calculation prices (see settings in PTMC platform).
- Multiple trade volume by the typical price (or by another calculation price)
- Calculate cumulative of trade volume (it's a denominator in the VWAP formula)
- Calculate cumulative for multiplier of Typical price by volume (it's a numerator in the VWAP formula)
- Calculate VWAP value (divide 4 step by 3 step)
On PTMC, you have various options for VWAP calculation. As shown in Figure 1, plus Close, Open, High and Low prices, you can choose:
- typical price, an average price for High+Low+Close,
- median price, an average price for High+Low,
- weighted price, an average price for High+Low+Open+Close.
Why should to use VWAP in your trading?
The Volume-Weighted Average Price (VWAP) indicator, is used as an important benchmark by professionals and institutions. Pros use VWAP to identify value opportunities and base major trading decisions on this level. They do that because VWAP is often seen as the best price of an instrument for any given trading day. Another reason to use this powerful indicator is that numerous trading robots are also coded with the aim of trading at better prices than the VWAP. Moreover, because it takes in count transactions volume, VWAP eliminates market noise better than a classic moving average.
Who should use Volume Weighted Average Price?
The VWAP value resets on daily basis, and it suits the needs of intraday traders. But If you’re a swing trader, you can still use this great trading tool in your strategy. And PTMC makes this possible by offering various parameters. Figure 2 shows that you can choose VWAP calculation based on a cycle of one day, week, or month. You can also choose Intraday calculation cycle and specify a customized cycle duration in minutes (ie 5 min, 15 min...), to make the VWAP tool suit your particular needs.
Trading with VWAP
While using VWAP calculated on a daily cycle, it will start at the open price of the trading day and will be very sensitive to price variation. But with the price progress through the day, it will become less sensitive. When you’re using VWAP, you should keep in mind that, while the price is above it, so there is an uptrend. At the contrary, if the price is below VWAP, there is a downtrend. I guess you wonder what is the behavior of this indicator when used in a sideways market. In this case, VWAP will simply plot through the middle of the price range and be flat. Looking the VWAP direction can then help you to know if you should use a trending or a ranging strategy. The following screenshots show what VWAP look alike when applied on CAC40 charts respectively for a bullish market (Figure 3a), a bearish market (Figure 3b) and a sideways market (Figure 3c).
How Professional traders use VWAP?
Institutional traders will often:
- buy when the price is below the VWAP because they can accumulate a position at a price that is better than the typical price.
- dispose of long trades and be short when the price is above the VWAP.
VWAP is used by HFT’s to buy/sell at a point which would not cause sudden movement is stock prices. It does not necessarily give trading signals but it helps in buying low and selling high. When used with other trading indicators it can definitely help in increasing the accuracy of your trading strategy. You should understand that this is only one metric of thousands, which is taken into account when allocating a large volume of orders.
How retail traders use VWAP?
While buying below and selling above VWAP is great, you can also use its crosses with the price. Retail traders want often follow the market momentum. When the price crosses above the VWAP line, it can be considered as an uptrend signal. And you can then search for buying opportunities. At the contrary, it’s usual to search for selling signals after price close below VWAP line. When you choose this strategy, you should know that :
- a strong buying pressure above the VWAP shows that price is driven by market’s participants to reach a new high.
- a strong selling pressure below the VWAP is an indication that price is being pushed down to reach a new low value.
The following chart (Figure 4) show price and VWAP line interaction. When the market is trending, you can notice that the last is often a support or a resistance for the former. This means that you can use the VWAP in your custom strategy to spotlight dynamic levels of support and resistance.
VWAP is a useful to see trends in the market and you can use it also as a dynamic support and resistance line. But to take better advantage of the VWAP, you need to use the VWAP Bands.
What are VWAP Bands?
Now, we will discuss what are VWAP bands and how you can use them.
To obtain VWAP Bands on your chart, you need to add to the VWAP 3 upper and 3 lowers lines. These lines will represent the variation of VWAP’s standard deviation. As shown in the following image:
- above VWAP, there are VWAP + standard deviation (upper SD1), VWAP + 2x standard deviation and (upper SD2) + 3x standard deviation lines (upper SD3).
- below VWAP, there are VWAP - standard deviation (lower SD1), VWAP - 2x standard deviation (lower SD2), and VWAP - 3x standard deviation (lower SD3) lines.
Prices and VWAP Bands interactions
To use VWAP bands in the best way, you need to understand how they interact with the stock price.
When VWAP bands plot on a sideways market’s chart, you can notice that :
- stock prices oscillate around the VWAP (Figure 6a), more precisely between the upper SD1 and the lower SD1 lines. There are also some spikes towards SD2 bands both above and below VWAP. And almost no price movement is noticed in SD3 bands areas.
- if a moderate trend occurs, prices generally range from SD1 to SD2 bands in bullish (Figure 6b) or bearish direction (Figure 6c), depending on the market. Moreover, on rare occasions, the price returns to the VWAP before being rejected again. Consequently, if the trend is bullish, the price won’t reach the lower SD1 (Figure 6b). And if the market is bearish, the price won't ever threaten the upper SD1 (Figure 6c).
VWAP bands trading in a sideways market
Based on what we said above, a trader can use SD2 bands as support and resistance when the stock price is ranging.
The common strategy that should be used then is to :
- buy when the price reaches lower SD2 line,
- sell when the price reaches upper SD2 line,
- set take profit to VWAP line.
While doing intraday trading in a sideways market, keep in mind that price can accelerate after a blink of an eye. So, you should stop a trade if the price moves a lot from SD2 bands toward SD3 lines.
VWAP bands trading on a trending market
On a trending market (let’s say a bullish one), trading with VWAP bands can follow these simple rules:
- go long after a bullish pullback on the VWAP line or on the upper SD1
- set a dynamic stop loss on the lower SD1
- the take profit can be set in numerous ways following trader’s goals per day/trade or Fibonacci levels. A trader can also take his profit when price passes through the upper SD2 and move toward SD3.
Trading is easy: you just need to set your trading parameters (size, SL, and TP), click on buy or sell, and that is it! But on the market, nothing is "either it is white, or it is black". So, there are some situations where you should trade wisely, even when using VWAP. These situations are when the price is neither ranging, neither trending.
VWAP is great but lagging (VWAP disadvantage)
Well, there is no doubt that VWAP is a great indicator you can use to have strong entries on the market. But, it’s not a holy grail that will make you successful without no effort from your part. The main flaw of VWAP indicator is that it lags. This is because of its cumulative formula.
To make it clear, this is an example: If you are using a 5 minutes chart, after 4 hours of trading, VWAP has been calculated for 48 periods. The lag associated with this would be similar to 48 periods moving average (Figure 7). As the day progresses, this lag will increase and at the end of the day, it will reach its highest value.
Conclusion about VWAP
Without no doubt, VWAP is a great tool that reduces market noise and helps you analyze better price behaviors. Even if, alone, it’s not the ideal indicator to have signal entries, to set stop loss and target prices, you can use it in combination with price action and another trading tools. To unleash the power of VWAP, you should add bands based on it’s standard deviation. These bands can be used as entry spots, dynamic stop loss and take profit levels. They’re an all in one tool for a trader.
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