Introduce
Technical indicators play an important role in financial market analysis. Some indicators aim to illustrate momentum, like the Relative Strength Index (RSI), StochRSI or MACD. Other indicators can be used to find potential entry and exit points on the chart, such as the Fibonacci Retracement tool, Parabolic SAR or Bollinger Bands.
But what is the most basic indicator? It can be said that it is the trading volume. Volume can be used as a tool to confirm a trend, identify potential reversal points, and many other strategies.
VWAP combines the power of volume with price action, creating a practical and easy-to-use indicator. Traders can use VWAP as a tool to confirm trends or a tool to determine entry and exit points.
Let's take a look at the definition of VWAP, how it works, and how traders can incorporate the indicator into their trading strategy.
What is VWAP?
VWAP is the acronym for volume weighted average price. As the name suggests, this is the average price of an asset over a certain period of time calculated by trading volume.
What makes VWAP an extremely useful indicator is the way VWAP incorporates trading volume into the average price formula. Some traders believe that trading volume is the most important indicator – other than price action. What makes VWAP an especially useful tool for both analysts and traders is the way VWAP combines these two important metrics into one indicator.
VWAP can provide an indication of market dominance trends, as well as important liquidity zones.
If you want to read more about some of the most useful technical indicators, you can check out the article 5 basic indicators used in technical analysis.
How to calculate VWAP
On most trading interfaces, you just need to select the indicator, and the system will take care of the calculations. However, you should also know the formula behind the indicator to use it more effectively. So how is VWAP calculated?
To calculate VWAP, we need to add the transaction value for each transaction (price multiplied by transaction volume), then divide by the total transaction volume.
VWAP = ∑ (Typical Price * Trading Volume ) / ∑ Trading Volumein there
Typical price = Highest price + Lowest price + Closing price / 3Let's calculate VWAP in 5 minutes for an asset. Here's how:
First, we need to calculate the typical price of the candle in the first 5 minutes. We add the Highest Price, Lowest Price, Closing Price, then divide by 3.
Then, multiply this typical price by the trading volume over that time period (in this case, 5 minutes). We call this value n1, because it is related to the first measurement period.
We divide n1 by the total trading volume until the end of that period. This result tells us the VWAP value in the first 5 minutes of trading.
To calculate the next VWAP values, we need to continue adding the new n value (n2, n3, n4...) of each time period to the previous values. Then, divide by the total trading volume until the end of that time.
Now you understand why VWAP is called a cumulative indicator, because the value increases over cumulative times.
What does VWAP tell traders?
For those interested in a more passive, long-term investment style, VWAP can be used as a benchmark for current market outlook. A simple strategy might be to only buy assets that are below the VWAP line, indicating the asset is likely undervalued.
However, some traders may consider the price crossing the VWAP line as a signal to enter a position. If the price breaks and goes above the VWAP line, traders will likely hold a long (buy) position. On the contrary, if the price breaks and goes below the VWAP line, traders may hold a short (sell) position.
In this sense, VWAP can be used similarly to a moving average. When the price is above the VWAP line, the market can be considered to be in an uptrend. Conversely, if the price is below the VWAP line, the market may be in a downtrend. Of course, this depends heavily on the context of the technical model and should be done with caution.
VWAP can also be used to identify liquidity zones. This indicator can be especially useful for large institutional traders looking to execute large orders. This indicator helps traders identify ideal entry and exit points for large trades, which can help reduce market impact.
VWAP can also be used to measure trade execution efficiency. In this sense, a buy order executed below the VWAP line can be considered an effective execution, since the execution price is lower than the average price of the asset based on trading volume. On the contrary, a buy order executed above the VWAP line can be considered an inefficient order execution, because the order execution price is higher than the average price of the asset based on trading volume.
The fact that some large traders buy below and sell above the VWAP line may bring another benefit to the market. In both cases, these actions push prices closer to the average. This ensures large traders do not push prices further than the average price through their price action. Remember, whale traders trade on a very large scale, so they can exert a significant influence on the market.
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Drawbacks of VWAP
VWAP is primarily effective as a one-day indicator. Trying to create a VWAP over multiple days can mean the average price is skewed. Therefore, VWAP is most effective for intraday analysis, i.e. for one trading day or less.
Like moving averages, VWAP is a lagging indicator, as it is based on past price data. Similar to a moving average, the more data there is, the greater the lag. Therefore, the 20-minute VWAP will respond to current price movements faster than the 200-minute VWAP.
It is important to note that because it is based on historical price data, VWAP does not have any predictive properties.
Although VWAP is an effective indicator, used by many traders, it should not be interpreted individually. For example, we mentioned that an asset can be undervalued when the price is below the VWAP line. However, in a strong uptrend, the price may not fall below the VWAP line for a significant period of time.
Therefore, traders who are waiting for this specific signal may sit on the sidelines and miss out on potential opportunities. However, missing out on a trade may not be such a bad thing. If a trader's market entry strategy specifies a specific event to occur and that event does not occur, then the trader should not proceed with the trade. However, if the strategy is thoroughly outlined and the trader is consistent with the strategy, then the trader will trade effectively in the long run. Regardless of the approach, it is important to understand and manage risk.
summary
VWAP is an indicator that tells traders the average price of an asset over a certain period of time, relative to trading volume.
Some traders may use VWAP to enter or exit positions when this indicator intersects with price. VWAP can be extremely useful when identifying potential entry and exit points for large trades.
VWAP is a lagging indicator, which means VWAP is not predictive of price. Some traders believe that this indicator should only be used for intraday analysis. As with all market analysis tools, VWAP should not be interpreted in isolation and the indicator is most effective when combined with other techniques.
