Today’s post is for a technical trader like you! Were going to introduce you to an indicator that takes into consideration price and volume, the Volume Weighted Average Price (VWAP) indicator!
What is the Volume Weighted Average Price?
VWAP is an indicator of volume-weighted average price, which is a technical analysis tool that shows the ratio of an instrument’s price to its total trade volume. it provides traders and investors with a measure of the average price at which an instrument is traded over a given period of time.
VWAP is commonly used as a benchmark by investors who want to be more passive in the market – usually pension funds and mutual funds – and traders who want to be sure whether an instrument was bought or sold at a good price.
To calculate VWAP, you use the following equation:
VWAP = ∑ (amount of instrument bought x instrument price)/total instruments bought that day
The standard VWAP is calculated using all of the orders of a given trading day, but it can also be used to look at multiple time frames.
The VWAP ratio is then presented on a chart as a line. It has been likened to a moving average, in that when the price is above the VWAP line the market is seen as in an uptrend, and when the price is below the VWAP the market is in a downtrend.
Reading and Trading the VWAP Signals
The signals from the VWAP could be confusing at some point. The reason for this is that the same signal from the indicator could be interpreted mainly in two different ways, Support, and Resistance with the VWAP or VWAP Breakout.
Support and Resistance
The VWAP indicator can also help you to identify support and resistance levels. Since the indicator averages the total periods for the day, it has psychological meaning on the chart. If the price approaches the VWAP from below and starts hesitating in the area, then the VWAP may be considered resistance. If this happens in the opposite direction, then the indicator might be able to support the price, creating a bullish movement. Below you see an example of the VWAP as a support and resistance level:
A breakout occurs when an instrument moves out of specific support or resistance level with a higher volume.
For the VWAP breakout, your strategy is to wait until the price goes above the VWAP indicator this means that the strength of the bullish move is strong. It is so strong that the price has managed to break its average value on the chart. Therefore, we get a long signal. The same is in force for a bearish breakout but in the opposite direction.
The VWAP indicator, just like the other technical indicators in a technical trader’s tool-set has no special powers. Unlike traditional moving averages which simply sum up the closing price of an instrument traded and divide it by a number of predetermined periods, the VWAP gives you the true average price of the instrument by additionally considering the transaction volume at a specific price. But if you use it the right way and under the right conditions, it can create many profitable trading signals.
The VWAP is a very good indicator, to be used by day traders, breakout traders, or momentum traders. Day traders find it especially helpful to know where the current market price stands in relation to the volume-weighted average price, in order not to buy instruments that diverge a lot from the VWAP. Breakout traders usually base their entry strategies on the VWAP breakout – a cross of the price below or above the VWAP which generates sell and buy signals, respectively. And momentum traders benefit from identifying early shifts in momentum if the price diverges is a large degree from the VWAP, accompanied by changes in underlying instruments fundamentals.
However, remember to apply money management rules when trading based on the VWAP indicator, and always look for additional confirmation signals from other technical indicators or candlestick patterns, chart patterns, or others. Just like with any trading tool, confirming the VWAP’s signals is a key measure to avoid false and lagging signals.