Known for its use by both institutional and retail traders, the VWAP indicator is one of the most well-respected trading tools. But how does VWAP work, and what does it tell us? Join us in this article as we dive into the world of VWAP trading, exploring its applications, advantages, and limitations.
The VWAP Indicator Explained
What does VWAP stand for? VWAP is an acronym for the Volume-Weighted Average Price indicator. There are two key terms here:
- Volume-Weighted: The calculation factors in the amount of volume traded during each candle.
- Average Price: The mean price of a security over a specified time frame.
What Is the VWAP Indicator?
The VWAP indicator is a technical analysis tool that calculates the average price of a security, weighted by the volume of trades over a given timeframe (called an anchor period), typically a set trading day. At first glance, its appearance is similar to a moving average. However, instead of closely following a security’s price, the VWAP indicator produces a relatively stable line that reflects the cumulative average price level over the anchor period.
By taking into account both price and volume data, the VWAP indicator provides a more accurate representation of an asset's fair value. This makes it particularly useful for traders looking to identify potential entry and exit points, as well as for gauging the overall market sentiment.
How to Calculate VWAP
Firstly, it’s important to note that the default VWAP calculation resets at the start of each trading session, meaning that when the next trading day begins, the calculation starts from the day’s first candle. This is unlike a moving average, which will simply take an average of the price over a given period, such as 5 or 20 candles.
At its simplest, the VWAP calculation can be expressed as:
VWAP = (Typical Price * Volume) / Volume
In practice, the specific steps involved are:
- Calculating the typical price from the session’s first candle, with the formula (High + Low + Close) / 3.
- Multiplying the volume of the first candle by the typical price, using (Volume * Typical Price).
- Calculating the sum of (Volume * Typical Price) from the first candle to the current.
- Calculating the sum of Volume from the first candle to the current.
- Dividing the sum of (Volume * Typical Price) by the sum of Volume to produce the VWAP value.
Because of how VWAP is calculated, the resulting line is virtually identical across all timeframes. For instance, the value of VWAP on a 5-minute chart will be very similar, if not the same, as the VWAP on a 30-minute chart.
This means that the standard VWAP indicator is useful for trading intraday on 1-hour charts or less, but it indicates very little when used on higher timeframes. However, longer-term traders can adjust the anchor period of the VWAP to a more suitable setting, like a week, month, quarter, or year, to realise the same benefits.
What Does VWAP Indicate?
The VWAP indicator is a versatile tool favoured by institutional and retail traders alike. Let’s take a look at some of the most common applications of VWAP.
Assessing Fair Value
By accounting for both volume and price data, VWAP can be used to determine how a security is valued compared to its “fair value.” If the VWAP level is considered to be a fair price, then movements beyond the VWAP can demonstrate that an asset is overvalued or undervalued.
This idea relates to the principle of mean reversion, which suggests that prices eventually return to their average values. Say a VWAP chart shows an asset spiking far below the line, bouncing off a key support level. Traders can then anticipate that the price will revert to the VWAP and enter a long position to capitalise on the move.
Evaluating Market Sentiment and Trends
The relationship between the price and the VWAP line can help traders gauge the broader market sentiment and trend direction. If the price sits above the VWAP line, the market can be considered bullish and vice versa. This is similar to how many traders use moving averages. However, a key advantage of VWAP is its stability, which makes identifying trends much easier with fewer false signals.
Of course, there are occasions when the price fluctuates around the VWAP line. In this scenario, traders can consider the market to be neutral and should watch for sustained breaks above or below the VWAP.
The concepts of mean reversion and evaluating trends might sound contradictory, but in reality, there’s nothing stopping traders from using both together. For example, you may identify a bullish break above the VWAP line and anticipate further bullishness. Then, you could look to enter when the price returns back to the VWAP line before it takes off bullishly again.
Like moving averages, the VWAP line acts as a dynamic support and resistance level. For instance, if the market is bearish, signified by price action below the line, then it’s unlikely that the asset will begin to move above its average price.
Instead, it may simply revert back to its mean and continue the bearish trend. In this sense, VWAP is a valuable tool for timing entries, as well as for setting stop losses and taking profits.
Assessing Entry Quality
Some traders, including institutional and algorithmic traders, use the VWAP as a benchmark to evaluate the quality of their entries. By comparing their executed prices to the VWAP, traders can determine if they are buying or selling at favourable price levels. Consistently entering above (if bearish) or below (if bullish), the VWAP indicates that their trades have a greater likelihood of success, given the concepts of fair value and mean reversion discussed earlier.
Limitations of VWAP
While the VWAP can offer some valuable insights and help traders decipher the markets, it’s essential to be aware of its limitations.
VWAP Lag and Distortion
Since the VWAP is a cumulative indicator, it can lag, especially toward the end of the trading day. At the start of the day, the VWAP is more sensitive. As the day progresses, the VWAP calculation takes in more data and becomes less sensitive. This can result in distortion, making it less reliable for late-day trading decisions.
Poor Application in Illiquid Assets
The VWAP indicator relies heavily on the volume of trades, which means its effectiveness is limited when analysing assets with low trading volumes. With little volume data to work with, the VWAP’s charting may appear erratic and might not provide a reliable representation of an asset’s fair value.
While rarely an issue for forex and commodities, certain stocks can be highly illiquid. You may want to forgo applying VWAP to these stocks, meaning you’ll need to consider other types of analysis instead.
Ineffective During Strong Trends
As mentioned earlier, the VWAP indicator may be less effective during strong trending markets. When the price persistently trades above or below the VWAP line, it could indicate that the market is experiencing a strong trend that may not revert to its average. In these situations, it’s best to consider other technical and fundamental factors before taking a trade or staying out of the market entirely until you’re confident the trend has finished.
Combining VWAP With Other Indicators
To overcome some of the limitations of the VWAP and enhance its effectiveness, traders can combine it with other technical indicators. Here are a couple of complementary tools you can use.
Traders can combine moving averages, like the Simple Moving Average (SMA) or the Exponential Moving Average (EMA), alongside VWAP to confirm trends and identify potential entry and exit points.
In the example above, we’ve used the slow-moving 200-period EMA (orange) to help identify potential entries. When the VWAP crosses above the EMA, a bullish trend is signalled, and vice versa. Traders could use the VWAP to determine that the price is trending in a given direction, then wait for validation from an EMA crossover before making their entry.
Relative Strength Index (RSI)
RSI is a momentum indicator that measures the speed and change of price movements. When used alongside the VWAP indicator, the RSI can help traders identify overbought or oversold conditions in the market and find mean reversion opportunities.
In this RSI and volume-weighted average price example, we see four areas that the RSI determines to be overbought or oversold. In each scenario, traders could begin to consider entries to capture the move back to the VWAP, given the confirmation signal from the RSI.
Your Next Steps
In summary, the VWAP indicator can be a powerful tool when used correctly. It offers some valuable insights, such as helping traders to assess an asset’s fair value and identify dynamic support/resistance levels. Wondering which steps to take from here? You can try this:
- Experiment with the VWAP across different timeframes and observe how the price reacts as it fluctuates above and below the line.
- Use this guide to help you develop a system for trading with the VWAP. You could use it for mean reversion and trend-following trades as a solid starting point.
- Already have a strategy? Try monitoring your entry quality by comparing your executed price to the VWAP.When you feel ready to start putting your strategy to work, open an FXOpen account to gain access to a full suite of trading tools and dozens of markets!
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