What Is the Volume-Weighted Average Price (VWAP)?
The Volume-Weighted Average Price (VWAP) is a tool used by traders to analyze intraday charts. It resets at the start of each trading session and represents the average price a security has traded at throughout the day, considering both volume and price. VWAP is essential for traders as it provides valuable insights into the trend and value of a security.
Understanding the Volume-Weighted Average Price
VWAP is calculated by adding up the dollars traded for every transaction (price multiplied by volume) and then dividing it by the total shares traded. The formula is as follows:
VWAP = Cumulative Typical Price x Volume / Cumulative Volume
Where Typical Price = (High price + Low price + Closing Price) / 3
Cumulative = the total since the trading session opened.
How to Calculate
To calculate the VWAP manually, follow these steps using a five-minute chart (these steps apply to any intraday time frame):
1. Find the average price of the stock traded during the first five-minute period of the day. Add the high, low, and close prices, then divide by three.
2. Multiply this average price by the volume for that period. Record the result in a spreadsheet under the column PV.
3. Divide the PV value by the volume for that period. This will give you the VWAP.
4. To maintain the VWAP throughout the day, continue adding the PV value from each period to the prior values. Divide this total by the total volume up to that point.
5. To simplify Step 3 in a spreadsheet, create cumulative PV and cumulative volume columns and apply the formula to them.
How Is VWAP Used?
Traders use VWAP in various ways. Some consider it a trend confirmation tool and build trading rules around it. For example, stocks with prices below VWAP may be viewed as undervalued, while those above it may be seen as overvalued. Traders may go long on stocks when prices move from below VWAP to above it, or sell or initiate short positions when prices move from above VWAP to below it.
Institutional buyers, like mutual funds, use VWAP to minimize market impact when entering or exiting positions. They try to buy below VWAP or sell above it, which helps push the price back toward the average instead of away from it.
The Difference Between VWAP and a Simple Moving Average
VWAP and a Simple Moving Average (SMA) may appear similar on a chart, but they are calculated differently and represent different results. VWAP considers both price and volume in its calculation, while SMA only incorporates price. SMA is calculated by summing closing prices over a certain period and dividing the total by the number of periods.
VWAP is a single-day indicator that resets at the open of each new trading day. Trying to create an average VWAP over multiple days could distort the indicator and provide incorrect results.
While some institutions prefer to buy when the price is below VWAP and sell when it is above, VWAP should not be the sole factor in decision making. In strong uptrends, prices may continue to rise without dropping below VWAP, potentially resulting in missed opportunities.
VWAP is based on historical values and does not inherently possess predictive qualities or calculations. It is important to note that VWAP is anchored to the opening price range of the day, causing the indicator to lag as the day progresses.
The Bottom Line
The Volume-Weighted Average Price (VWAP) is a valuable technical analysis tool that considers both price and volume to determine the average price of a security. Traders use VWAP to gain insights into a security’s trend and value. However, it is essential to consider other factors and not solely rely on VWAP when making trading decisions.