Volume Weighted Average Price (VWAP) strategies are a popular type of technical analysis used by active traders to identify entry and exit points for trading securities, such as stocks and cryptocurrencies. With VWAP, traders gain insights into the price levels that buyers and sellers are fighting over and the market’s future direction.
Most VWAP activity occurs among institutional powerhouses, such as hedge funds and investment banks. But, that doesn’t mean everyday traders can’t leverage VWAP to understand market sentiment. When used strategically, traders can spot key trading signals to profit and get clues on where the smart money is heading.
- VWAP is a technical indicator that uses volume and price to find the true average price an asset has traded at through the day.
- VWAP often gets used to identify whether buyers or sellers are in control of price action, what the market trend will look like at market open, and where potential support and resistance for price action are.
- There are two basic VWAP setups: pullbacks and breakouts. Traders looking for the best price before a security’s price action runs higher tend to use VWAP pullback setups. On the other hand, traders who focus on finding strong breaks above VWAP use VWAP breakout setups.
- While VWAP can get used on its own, combining signals from other technical indicators such as support and resistance, moving average crossovers, and RSI can help confirm trading hypotheses.
What is Volume Weighted Average Price (VWAP)?
Volume weighted average price (VWAP) is a commonly used trading benchmark that takes volume and price into the calculation to identify the true average price a security has traded at throughout a trading period. If you only use the closing values to find the average price, it depicts an inaccurate representation of how an asset is doing. That is because it doesn’t account for the various timeframes and fluctuations in price and volume.
Since VWAP factors in the volume of transactions at specific price points, it allows traders to gauge a security’s current and future trend, as well as its strength. That means determining whether there is more buying or selling volume and whether the security is overpriced or underpriced compared to the average trading price. Knowing the answers to questions such as whether an asset closed at a low with high volume or whether it moved to a new high on low volume helps you find profitable entry and exit positions.
At a high level, the VWAP indicator is a ratio of a security’s average price compared to trading volume over a set timeframe. In other words, a mathematical formula. To understand the mechanics of VWAP, we need to take a look at how it gets calculated:
To calculate VWAP, we use intraday data, meaning we take the opening price of the asset for each day and adjust it in real-time until the session closes. The formula above takes the cumulative typical price times volume and divides that by the cumulative volume. While this formula is a bit complicated, the good news is that when you add the VWAP indicator to a chart, all these calculations will be done automatically for you.
What is VWAP Useful?
VWAP is often used to identify whether buyers or sellers control the price, determine the market trend when the market opens, and act as support and resistance for price action. When an asset is trading above VWAP, that is a bullish indicator. The buyers are in control, and the majority of traders are bidding higher. When an asset closes below VWAP, that is a bearish indicator, and the sellers are in control. If VWAP is rising, the buyers are in control, and if it is falling, the sellers are in control. If VWAP is flat, the price is in a trading range, so nobody is in control.
VWAP is a trend reversal indicator that is useful when trading large-cap stocks and identifying potential long traps and short traps when trading small-cap penny stocks. Smart money typically uses VWAP as support and resistance levels by buying when the price is below VWAP and selling when it’s above. That way, they can push the price towards the average rather than away from it.
While retail traders tend to be less concerned about a security’s moving market price, large institutional investors often use VWAP to determine the quality of large order executions. For example, they can use VWAP to move in and out of positions while limiting their impact on the market.
Let’s say a portfolio manager wants to acquire tens of thousands of shares of Apple but also wants to buy them at a below-average price for that trading session. They would try not to buy shares at a price above VWAP to avoid artificially inflating its price. Their measurement of success would get based on comparing the average purchase price of Apple stock and the VWAP at the time of purchase.
If a hedge fund manager owns a significant number of shares of stock in a company and wants to sell their position, one of their concerns would be the daily trading volumes in that market. If it is too low, they risk driving the stock price down each time they try to sell. So, a workaround would be to split the selling process into smaller pieces over a set timeframe. Vice versa, if they want to build a bigger position, they would use VWAP as a benchmark against their purchase price because it influences intraday price action.
VWAP vs. Simple Moving Average (SMA)
A simple moving average (SMA) calculates the average closing price of an asset over a set number of days. For example, to calculate the 10-day moving average of shares of Roku stock, you would add up its closing price on each of the past 10 days and then divide by 10. Once the moving average gets plotted on a chart, it will appear as a line that follows price action.
When both the VWAP and SMA are plotted together on a chart, they will look very similar. However, they calculate different things. While moving average crossovers adds additional value to trading setups, VWAP is unique because it reacts to both price action and volume. SMAs only react to price action.
There are two basic VWAP setups: pullbacks and breakouts. VWAP pullback setups are highly popular among day traders looking for the best price before the security’s price rises higher. Meanwhile, VWAP breakout setups focus on strong breaks above VWAP. For more on day traders, click here.
VWAP pullback setups are often used by aggressive traders and involve closely watching price action as it approaches VWAP. With this approach, you will wait for a break of VWAP and then read the tape to check on the time and sales. The goal here is to identify when there is high selling pressure, which is indicated by the order flow on the tape moving quickly. Once you figure out when the selling pressure will subside, then you enter the trade. Note that reading the tape like a pro will take some time and practice.
A real-life example is a VWAP cross-long setup. If we look at the MicroVision example below, we can see that it is getting beaten down on the chart, selling off from $15.67 to $13.27. We can see that at the points where there is a slight runup, the volume is pushing the price up above VWAP and then quickly pulling back (crossover occurring here). Before going in long at the crossover, make sure the volume is holding up.
Sometimes in this situation, VWAP will act as support, but not always. Take note of the selling vs. buying pressure in the volume to check if the selling pressure is decreasing. Additionally, do not set your stop loss right at VWAP because that makes it easier for market makers or algorithms to take you out of the trade. A few other things to consider with this setup are the daily chart, intraday volume, and market condition.
If you are a beginner, VWAP breakout entries are a great alternative to VWAP pullback setups. With this setup, you wait for the security to test VWAP to the downside and look for the price action to close above VWAP. You will then open a position right above the high of the candle that closed above VWAP.
A real-life example of this is a breakdown short setup. In the MicroVision example below, we can see that it is trading around VWAP, but then it breaks down to $12.47 later on. Once it breaks down below VWAP, traders consider it bearish short-term, which is why it was selling off.
While MicroVision is below VWAP, we can see that it is holding its lows around the $12.50 to $12.70 range, but it’s not trending down even further. This is a potential short trap, where you see the stock below VWAP for an extended amount of time with low volume to attract short sellers to short the gap fill.
However, later on, we can see the volume starting to pick up and the chart starting to break above VWAP and holding to form a higher lows trend. So, the traders previously shorting the stock would need to start buying to cover. With this setup, we need to look at volume to make sure the stock is holding higher lows and consolidating. If it keeps on trending down and reaching lower lows, it’s less likely to breakout.
Setting VWAP Targets
Onto the most important part of trading – profiting. There are several ways to determine your profit potential when trading, including selling at the high, selling at a Fibonacci level, or selling into climatic price action.
Selling at the High of the Day
This strategy works well when you want to exit a winning trade. After taking a position, you would take profit at the high of the day and place your stop target below the recent low. For the most part, experienced traders tend to sell their long positions into strength, whereas beginners try to buy these breakouts. Once you’ve started trading for a while, you may begin noticing a pattern where the next round of breakouts after the morning breakouts in the first 20-40 minutes following the market open will tend to fail.
While beginners are busy looking for breakouts, more experienced traders get the liquidity they need to unload their position. Trading is a zero-sum game, meaning if you make a winning trade, someone else on the other end is losing. With any trade, pay attention to who and where the winners are averaged in versus the bagholders.
Selling at a Fibonacci Level
If you’re a bullish investor looking for big gains, set your price targets at a Fibonacci level. Based on Fibonacci numbers, each level is associated with a percentage that indicates how much the price has pulled back, or reversed, from a previous move. The official Fibonacci retracement levels are 23.6%, 38.2%, 61.8%, and 78.6%, though 50% gets commonly used too.
With this setup, you assume that the asset will break through the daily high and keep running up. If your target gets hit, you can make massive gains, but the tradeoff is that the odds of hitting your target are slimmer.
Selling Into Climactic Price Action
Sometimes a security’s price action will keep pushing up to higher highs as buyers continue buying and shorts cover. What eventually happens is a parabolic movement, as you can see in the example below with Roblox.
As Roblox keeps reaching new highs on strong volume, it is time to sell and take profit. Because the price got pushed up so quickly in such as short period, it’s harder for the stock to maintain that price. As we can see at the end of the chart, there are signs of the price starting to fall just as quickly as it rose. As the price consolidates, you can look for another entry point later on.
Limitations of VWAP
As powerful as VWAP is, the indicator does have several limitations.
The biggest downside to VWAP is that it is a lagging indicator. While it gives traders insights into current and future market trends, it relies on historical data. So, it will not always make accurate forecasts. However, this issue is common among many technical analysis tools.
Market Open Constraints
Because of the way the VWAP formula gets calculated, and how each trading session starts fresh, there won’t be enough recent data right after markets open to provide a clear picture of where the market is heading. Since traders can only confirm market momentum once the price moves away from VWAP, using it at the market open will only lead to confusion. In other words, VWAP can’t get used then.
Since the first candle at market open has no prior candle it can refer to, it is relatively weak, and often the first few price candles will overlap VWAP. Another issue is that there are usually higher trading volumes at market open and close, which makes it harder to find the trend and determine whether VWAP will as a support or resistance, if at all.
While many traders use VWAP exclusively, combining signals from different technical indicators can help confirm your hypotheses. Of course, that doesn’t mean you should throw as many indicators as possible onto your charts since that would probably hurt you more than help. But, by using additional signals, you can boost your confidence for each trade.
For example, identifying clear zones of support and resistance for price action can help you confirm a buy or sell signal. Traders often use these areas to identify points where the price might slow down or reverse.
Another popular technical indicator is moving average crossovers. I typically use the 50 MA and 200 MA to gauge the market trend. When the 50 MA crosses above the 200 MA, I interpret that crossover as a bullish reversal pattern that indicates the price will rise. When the 50 MA crosses below the 200 MA, that is a bearish reversal pattern that indicates the price will fall.
Tools to Consider
If you are looking for a platform that can help with leveraging VWAP strategies, consider using TradingView. TradingView is a subscription-based charting platform used by millions of investors and traders worldwide. You can also create custom VWAP strategies on TD Ameritrade’s trading platform, thinkorswim. Currently, thinkorswim can be accessed on the web, desktop app, or mobile devices. While I currently have not used either platform extensively, they are both great options if you are interested in taking your trading strategies to the next level.
The Bottom Line
Traders often use VWAP to understand what’s happening in the market and identify potential entry and exit points. But, VWAP gets held back by several restrictions. It is a lagging indicator and isn’t suitable for use at the market open. Additionally, it provides limited insights for investors who have longer time horizons.
With that said, understanding VWAP can help you glean insights into what smart money is doing in the market. Many experienced traders also rely exclusively on VWAP to make bank. As you start getting more familiar with VWAP, you may come to realize that it works very similar to many other indicators in that you will win sometimes and lose sometimes. With trading and investing, it’s impossible to get everything right every single time. If you end up incorporating VWAP into your trading strategy, remember that you still need to put in the time and effort to make solid trading decisions. The markets are constantly changing, so we need to adapt to them and keep growing and learning.