List of contents
Introduction
What is VWAP?
How to calculate VWAP
What are the benefits of VWAP
Kelemahan VWAP
Closing
Introduction
Technical indicators are an important part of financial market analysis. Some of these indicators aim to depict momentum, such as the Relative Strength Index (RSI), StochRSI, or MACD. Some others can be used to find potential points of interest on a chart, such as Fibonacci Retracement, Parabolic SAR, or Bollinger Bands.
However, what exactly is the most fundamental indicator? So to speak, volume. Volume can be used as a tool to confirm trends, identify potential reversal points, and many other strategies.
VWAP combines the power of volume and price action to create a practical and easy-to-use indicator. Traders can use VWAP as a trend confirmation tool, or as an instrument to identify entry and exit points.
We will discuss what VWAP is, how it works, and how traders can incorporate it into their trading strategy.
What is VWAP?
VWAP stands for volume-weighted average price. As the name suggests, the average price of an asset over a certain period is calculated based on volume.
VWAP is a very powerful indicator because volume is factored into the average price calculation. Some traders argue that volume is the most important metric – besides the price action itself. VWAP is very useful for analysts and traders because these two important metrics are combined into one indicator.
VWAP can provide an indication of dominant market trends, as well as important areas of liquidity.
If you want to read more about some of the most useful technical indicators, check out 5 Important Indicators Used in Technical Analysis.
How to calculate VWAP
In most trading views, you simply select an indicator, and the calculations will be done for you automatically. However, even so, it is helpful to know the formula behind it all, so you can use it more efficiently. So, how do you calculate VWAP?
To calculate VWAP, we need to add up the value traded in each transaction (price multiplied by volume), then divide it by the total volume.
VWAP = ∑ (Typical Price * Volume ) / ∑ Volumewhere
Typical Price = High + Low + Close / 3For example, we will try to calculate the 5-minute VWAP for an asset. Things we need to do:
First, we need to calculate the average price of the first 5 minute candlesticks. We add the High, Low, and Close, then divide that number by 3.
We multiply the average price by the volume for that period (in this case, 5 minutes). Let's call the value n1, because it is the first measurement period.
We divide n1 by the total trading volume up to that period. This will provide the VWAP value for the first 5 minutes of trading.
To calculate successive VWAP values, we must continuously add new n values (n2, n3, n4…) from each period to the previous value. Then, we divide it by the total volume up to that point.
Now we understand why VWAP is called a cumulative indicator, because its value increases with successive additions.
What are the benefits of VWAP
For those interested in a more passive, long-term investment style, VWAP can be used as a benchmark for the current market outlook. A simple strategy might be to simply buy assets that are below their VWAP line, indicating that they are potentially undervalued.
If the price crosses the VWAP line, some traders interpret it as a signal to enter a trade. If the price breaks out and rises above the VWAP, they will enter a long position. Conversely, if the price breaks out and falls below the VWAP, they will enter a short position.
In this respect, VWAP is similar to a moving average. When the price is above the VWAP line, the market can be interpreted as bullish. At the same time, if it is below the VWAP line, the market is bearish. This, of course, depends greatly on the context of the technical pattern and should be observed with caution.
VWAP can also be used to identify areas of liquidity. Can be very useful for institutional traders who want to fill large orders. Indicators help them determine ideal entry and exit points for large trades, which can reduce market impact.
VWAP can also be used to measure the efficiency of the trade execution process. In this case, a buy order executed below the VWAP can be considered a good fill, as it is below the average price of the asset by volume. Conversely, a buy order executed above the VWAP can be considered a bad fill, as it is executed above the asset's average price by volume.
Some large traders buy assets below the VWAP and sell above it. This could offer other benefits to the market. These actions push the price closer to the average, ensuring that large traders do not push the price further from the average with their actions. Remember, whales trade at some of the largest sizes, and can have a huge impact on the market.
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Kelemahan VWAP
VWAP is more useful as a one-day indicator. If you try to create VWAP for several days, the average value will be distorted. Thus, VWAP will work best in intraday analysis, that is, analysis that considers trades within one day or less.
Like the moving average, VWAP is a lagging indicator, based on previous price data. So, the more data there is, the greater the lag. Thus, the 20-minute VWAP will react more quickly to current price movements than the 200-minute VWAP.
It's also important to remember, because it is based on past price data, VWAP has no quality in predicting prices.
Although VWAP is a strong indicator used by many traders, we cannot deny that this indicator also has weaknesses. For example, we have discussed that an asset can be considered undervalued when its price is below the VWAP line. However, in a strong uptrend, the price may not fall below the VWAP for quite some time.
Thus, traders who wait for these signals may end up falling behind and missing out on potential opportunities. If a trade entering strategy dictates that a certain event should occur, and that event does not occur, they should not enter the trade. However, if the strategy is well thought out and consistently stick to it, they will be successful in the long run. Whatever the approach, it is important to understand and manage risk.
Closing
VWAP is an indicator that tells traders what the average price of an asset is in a certain period based on volume.
Some traders can use VWAP to enter or exit positions based on price crossings. This can be very useful in helping identify potential entry and exit points for large trades.
VWAP is a lagging indicator, which means it has no quality in predicting prices. Some traders argue that this indicator works best when used in intraday analysis. As with any market analysis tool, VWAP should not be applied in isolation, as it works better when combined with other techniques.
