Introduction
Technical indicators are an essential part of financial market analysis. Some of them aim to illustrate inertia, such as the RSI (Relative Strength Index), the StochRSI, 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? It's probably the volume. Volume can serve as a tool for confirming a trend, identifying potential reversal points, and many other strategies.
The VWAP combines the power of volume with price action to create a practical, easy-to-use indicator. Traders can use VWAP as a trend confirmation tool, or as an instrument to identify entry and exit points.
We've looked at what risk/reward is and how traders can incorporate it into their trading plan.
What is VWAP?
VWAP stands for volume weighted average price. More concretely, it is the average price of an asset for a given period, weighted by volume.
What makes VWAP a particularly powerful indicator is the way it incorporates volume into the average price calculation. Some traders believe that volume is the most important metric, aside from the price action itself. What makes VWAP a particularly useful tool for analysts and traders is how it combines these two important metrics into a single indicator.
The VWAP can give an indication of the prevailing market trend, as well as areas of significant liquidity.
If you want to learn more about some of the most useful technical indicators, check out 5 Essential Indicators Used in Technical Analysis.
How to calculate VWAP
On most trading interfaces, you can simply select the indicator and the calculations will be done for you. Either way, it can be helpful to know the formula that comes with it so you can use it more effectively. So how is VWAP calculated?
To calculate VWAP, we need to add up the traded value for each transaction (price times volume) and then divide the result by the total volume.
VWAP = ∑ (Prix typique x Volume ) / ∑ VolumeOr
Typical price = high + low + close / 3Let's calculate the 5-minute VWAP of an asset. Here is what we need to do:
First, we need to calculate the average price of the first 5 minute candlestick. We add the values Top, Bottom, Fence, and divide this number by 3.
We multiply the average price with the volume for that time period (5 minutes, in this case). Let's call this value n1, because it concerns the first measured period.
We divide n1 by the total trading volume up to that period. This gives us the VWAP value for the first 5 minutes of trading.
To calculate successive VWAP values, we need to keep adding the new n values (n2, n3, n4…) from each period to the previous values. Then we need to divide this figure by the total volume up to that point.
We now understand why the VWAP is called a cumulative indicator: the values increase with successive additions.
What VWAP tells traders
For those interested in a more passive, longer-term style of investing, the VWAP can be used as a benchmark for the current market outlook. A simple strategy can be to only buy assets that are below their VWAP line, which indicates that they are potentially undervalued.
That being said, some traders may use the price crossing the VWAP line as a signal to enter a trade. If the price breaks through and exceeds the VWAP, they can go long. Conversely, if the price crosses and falls below the VWAP, they can take a short position.
In this sense, VWAP can be used similarly to moving averages. When the price is above the VWAP line, the market can be interpreted as bullish. Conversely, if it is below the VWAP line, the market may be bearish. Of course, this is highly dependent on the context of the technical setup and should be interpreted with caution.
VWAP can also be used to identify liquidity zones. This can be particularly useful for institutional traders who want to execute high volume orders. The indicator helps them determine the ideal entry and exit points for large trades, which can reduce their impact on the market.
VWAP can also be used to measure the efficiency of trading execution. In this sense, buy orders executed below the VWAP can be considered good executions, as they are below the volume-weighted average price of the asset. Conversely, buy orders executed above the VWAP may be considered poor execution because they are executed above the volume-weighted average price of the asset.
The fact that some large traders are buying below the VWAP and selling above it may provide another advantage for the market. These actions bring the price closer to the average in both cases. This ensures that large traders do not shift prices away from the average with their actions. Keep in mind that whales trade the largest orders and could have a significant impact on the markets otherwise.
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Limits du VWAP
The VWAP is primarily useful as a daily indicator. Trying to create a VWAP over multiple days can mean the average is distorted. As such, VWAP works best for intraday analysis, that is, analysis that takes into account one trading day or less.
Like moving averages, VWAP is a trailing indicator because it is based on past price data. Just like moving averages, the more data there is, the greater the shift. Therefore, a 20-minute VWAP will react more quickly to current price movements than a 200-minute VWAP.
It is important to keep in mind that since it is based on past price data, VWAP has no predictive quality.
While VWAP is a powerful indicator used by many traders, it should not be interpreted in isolation. For example, we have seen that an asset can be considered undervalued when the price is below the VWAP line. However, in a strong uptrend, the price may not drop below the VWAP for a considerable period of time.
Therefore, traders who wait for this specific signal may get left behind and miss out on a potential opportunity. That said, missing a trade doesn't have to be the end of the world. If a trader's entry strategy requires a specific event to occur and that event does not occur, they should not enter a trade. However, if a strategy is well thought out and the trader sticks to it, the strategy should be profitable in the long run. Regardless of the approach taken, it is essential to understand the risks and manage them.
To conclude
VWAP is an indicator that tells traders what the average price of an asset is for a given period, relative to volume.
Some traders may use VWAP to enter or exit positions based on its crossover with price. It can be particularly useful in helping identify potential entry and exit points for large trades.
The VWAP is a trailing indicator, which means it has no price prediction ability. Some traders claim that it is best used for intraday analysis. Like any other market analysis tool, VWAP should not be interpreted alone and works best when combined with other techniques.