Technical analysts use many technical indicators to understand a stock’s price movement and volume or any other security. This analysis is crucial to create a healthy portfolio that can navigate market fluctuations. One of the many indicators commonly used by traders is the volume weighted average price (VWAP). Given here is the meaning of this indicator and its related details.
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What is Volume Weighted Average Price (VWAP)?
Volume Weighted Average Price (VWAP) refers to the technical indicator that is used in financial markets. This indicator represents the average price of a security over a specified time period, weighted by the trading volume during that period. This indicator is calculated after taking into consideration both the price and the volume traded during the period to provide a more accurate representation of the average price at which the security was traded.
How to calculate VWAP?
VWAP is calculated over a specific period which can be a day or week or month. Traders have to consider the high, low, and closing prices for the target period. The next step is to calculate the average price of the above three specified prices which is dividing the sum of the three prices by 3. This average price also known as the typical price is then multiplied by the volume of the target prices. The last step is to then divide the resultant figure by the cumulative volume of the target period. The resultant figure is the VWAP. This VWAP can be calculated for a number of periods and plotted on the stock charts. This will help traders understand the movement of the stock in a better manner and take strategic decisions.
The formula for Volume Weighted Average Price is given below.
Volume Weighted Average Price (VWAP) = Typical Price * Volume / Cumulative Volume of the period.
How to use the VWAP indicator?
Traders and investors can use the VWAP to understand the market sentiment and to navigate the market volatility. The VWAP indicator can be used in the following manner.
Confirmation of trend
VWAP indicator can be used to identify and confirm the ongoing trend. When the current price of the security is trending in the upwards direction and has been in a similar position consistently above VWAP, it indicates a bullish trend. On the other hand, when the current price is consistently showing a downtrend and is below the VWAP, it indicates a bearish trend.
Understanding buy and sell signal
The VWAP can be used to understand the crucial buy and sell signals, i.e., the entry and exit points for security. When the current price is above the VWAP, it indicates the security is overvalued which may be interpreted as a selling signal. On the other hand, when the VWAP is below the current price, traders can interpret this as the security being undervalued indicating a buy signal.
Volume analysis
Traders can also use VWAP for volume analysis of a security. When the VWAP is higher than the current price of the security, it indicates that there is more buying than selling during the target period and vice versa.
Use in algorithmic trading
The use of algo trading has been on the rise in recent years. There are many trading software that can help traders in calculating the VWAP correctly without any hassles or errors. Traders can therefore use VWAP in algo trading for efficient execution of trades when the VWAP triggers the buy and sell signals.
What is the difference between VWAP and moving averages?
The Volume Weighted Average Price (VWAP) and moving averages are both popular technical indicators used by traders and investors to analyze price trends and make trading decisions. Some of the key differences between the two are tabled below.
| Category | VWAP | Moving Averages |
| Calculation method | The VWAP is calculated by multiplying the price of each trade (high, low, and closing price) by the corresponding trading volume and then dividing the resultant number by the cumulative trading volume. | Moving averages, on the other hand, are calculated by averaging the price of a security over a specific period, typically using a simple (SMA) or exponential moving average (EMA). |
| Time period | The VWAP is typically calculated for a specific time period, such as a day or week, or month and is based on the trading volume during that period. | Moving averages can be calculated for different time periods, such as a 50-day moving average or a 200-day moving average. |
| Weights | The VWAP is a volume-weighted indicator, which means that it gives more weight to trades with higher trading volume. | Moving averages are typically simple or exponential averages, which give equal weight to each price point in the time period. |
| Interpretation | The VWAP is commonly used to determine the average price at which a security has traded over a specific period and is used to identify trends or trend reversals, confirm the market sentiment, and execute trades by understanding the buy and sell signals. | Moving averages are used by traders and investors to identify trends and signal potential buy or sell signals which are based on price crossovers with the moving average line. |
Conclusion
VWAP is often used by traders and investors as well as by institutional traders who deal with large orders. VWAP can provide an indication of the average price of the security that is most likely to occur for an order over a longer period of time. This information is crucial to assess whether they have made a sound trade or investment for ultimately a profitable portfolio.
FAQs
The ultimate goal of using the VWAP is to compare the current price of a security to the derived VWAP and provide a benchmark for traders to decide the optimum entry and exit points of a trade.
The typical price in VWAP calculation is the sum of the high price, low price, and the closing price of a security during the defined period and dividing the said sum by 3
VWAP can be used to understand the ongoing trends and possible trend reversals as well as a good buy and sell signals, however, it is prudent to use other fundamental and technical analysis indicators for confirmation of results.
There is no role of the opening price in VWAP calculation unless it is the high or low price of the defined trading period or equal to the closing period
