Content

  • Introduction

  • What is the VWAP?

  • How to calculate VWAP

  • What does the VWAP indicate to traders?

  • VWAP Limitations

  • Conclusion


Introduction

Technical indicators play an essential role in the analysis of financial markets. Some of them are intended to illustrate "momentum" - such as the Relative Strength Index (RSI), the Stochastic RSI or the MACD. Others can be used to find potential points of interest on a chart - such as the Fibonacci Retracement tool, Parabolic SAR or Bollinger Bands.

But what is the most fundamental indicator that we can find? Probably the volume. And volume can be used as a tool to confirm a trend, identify potential reversal points and for many other strategies.

The VWAP combines the power of volume with price action to create a practical and simple indicator. Traders can use the VWAP as a trend confirmation tool, or as an instrument to identify entry and exit points.

Let's proceed, then, to analyze what the VWAP is, how it works and how traders can incorporate it into their trading strategy.


What is the VWAP?

VWAP stands for volume-weighted average price. As the name suggests, this is the average price of an asset over a given period of time, weighted by volume.


ejemplo de gráfico de vwap


What makes VWAP a particularly powerful indicator is the way it incorporates volume into the average price calculation. Some traders think that volume is the most important metric there is – apart from the price action itself. What makes the VWAP an especially useful tool for both analysts and traders is the way it combines those two important metrics into a single indicator.

The VWAP can give an indication of the dominant market trend as well as important areas of liquidity.

If you want to read more about some of the most useful technical indicators, take a look at 5 Essential Indicators Used in Technical Analysis.


How to calculate VWAP

In most trading interfaces, you can simply select the indicator and the calculations will be done automatically for you. Still, it can be helpful to know the underlying formula so you can use it more efficiently. So how is VWAP calculated?

To calculate VWAP, we need to add the volume traded in each transaction (price multiplied by volume), and then divide it by the total volume.

VWAP = ∑ (Typical Price * Volume) / ∑ Volume

where


Typical Price = High + Low + Close / 3

Let's proceed to calculate the 5-minute VWAP line for an asset. This is what we will have to do:

  1. First, we need to calculate the typical price for the first 5-minute candle. We add the High, Low and Close, and divide the resulting number by 3.

  2. We multiply the typical price by the volume of said period (in this case, 5 minutes). We will call this value n1, since it refers to the first measured period.

  3. We divide n1 by the total volume that has existed up to that moment. This will give us the VWAP value for the first 5 minutes of trading.

  4. To calculate the successive VWAP values, we have to continue adding the new values ​​n (n2, n3, n4...) of each period, to the previous values. Next, we must divide the result by the total volume up to that moment.

Now we understand why the VWAP is considered a cumulative indicator - since the values ​​are increased by successive additions.


What does the VWAP indicate to traders?

For those interested in more passive and longer-term investment styles, the VWAP can be used as a benchmark for the current market outlook. A simple strategy could be to only buy assets that are below their VWAP line - which would indicate potential undervaluation.

That said, some traders may use the price crossing the VWAP line as a signal to enter a trade. If the price violates and exceeds the VWAP, they may be left in a long position. Conversely, if the price breaks below the VWAP, they may be left in a short position.

In this sense, the VWAP can be used in a similar way to moving averages. 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 may be bearish. This, of course, is highly dependent on the context of the technical pattern and should be taken with caution.

The VWAP can also be used to identify areas of liquidity. This can be especially useful for institutional traders looking to fill large orders. The indicator helps them determine the ideal entry and exit points for large trades, which can lessen their impact on the market.

VWAP can also be used to measure the efficiency of operation execution. In this sense, buy orders executed below the VWAP can be considered good deliveries, since they are below the volume-weighted average price of the asset. Conversely, buy orders executed above the VWAP can be considered bad fills, as they are executed above the volume-weighted average price of the asset.

The fact that some large Tartars buy below the VWAP and sell above it may offer another benefit to the market. These actions bring the price closer to the average in both cases. This ensures that large traders do not push prices beyond the average with their actions. Keep in mind that whales sometimes trade large sizes, and could otherwise have a substantial impact on the markets.


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VWAP Limitations

The VWAP is primarily useful as a single day indicator. Trying to create a VWAP over several days could mean that the average is distorted. As such, the VWAP works best for intraday analysis, that is, analysis that considers one trading day or less.

Like moving averages, the VWAP is a lagging indicator as it is based on previous price data. Similar to a moving average, the more data there is, the longer the delay. As such, a 20-minute VWAP will react faster to current price movements than a 200-minute VWAP.

It is important to note that since it is based on past price data, the VWAP has no predictive qualities.

While the VWAP is a powerful indicator used by many traders, it should not be interpreted in isolation. For example, we have discussed that an asset can be considered undervalued when the price is below the VWAP line. However, in a strong uptrend, the price may not be lower than the VWAP for a considerable period of time.

As such, traders who are waiting for this specific signal could sit on the sidelines and miss out on a potential opportunity. That being said, losing a trade may not be the end of the world. If a trader's entry strategy dictates that a specific event happen, and that event does not happen, he or she should not enter a trade. However, if your strategy is well thought out and you stick to it consistently, you should be doing well in the long run. Regardless of the approach, it is crucial to understand and manage risks.


Conclusion

The VWAP is an indicator that tells traders what the average price of an asset is for a given period, relative to volume.

Some traders can use the VWAP to enter or exit positions based on their crossover with the price. It can be especially useful to help identify potential entry and exit points for large trades.

The VWAP is a lagging indicator, meaning it has no predictive qualities for price. Some traders argue that it is best when used for intraday analysis. As with any other market analysis tool, the VWAP should not be interpreted in isolation and works best when combined with other techniques.