Volume Weighted Average Price Trading Strategy

As stock market investors, we have access to a wealth of data and a variety of tools to aid in selecting profitable investments. For fundamental investors, the focus lies on analyzing a company's revenue and profit growth, often through yearly reports, management interviews, brokerage data, and valuation ratios. Conversely, traders or those employing a more technical approach closely monitor stock prices, using various technical indicators to time their entries and exits. One such indicator, the volume-weighted average price (VWAP), is the focus of this article. We'll explore what Volume Weighted Average Price Trading Strategy is, how to calculate it, and its application in the stock market.

What is the Volume-Weighted Average Price

The Volume Weighted Average Price (VWAP) is a technical analysis indicator that measures the average price at which a specific securities trades over a specified period. Unlike conventional moving averages, which determine the average price based solely on time, VWAP considers the volume of trades at each price level. This implies that the price of larger trades has a higher impact on the VWAP than smaller deals. VWAP is frequently used by institutional traders who need to execute big orders over a day or more.

Limitation of VWAP Trading Strategy

• Intraday Only: VWAP resets at the start of each trading day, thus it only applies to intraday trades.
• Big Orders: Institutional traders may utilise VWAP to make big orders, thereby influencing the VWAP queue.
• Lagging Indicator: VWAP is a lagging indicator by definition, as it is an average.

Chart and VWAP Trading Example

The VWAP line, a blue line, is an intraday strategy filter for intraday traders. In a sideways price action, intraday traders often use a strategy based on a reversion to the average price for the day.

Additional regions are added to the chart representing significant distances from the VWAP line.

An example is initiating a long entry when the price closes in a support region, with a stop-loss order outside the farthest line and a profit target at the VWAP line. This method can fail quickly on trending days and make multiple successful trades on sideways days. Additionally, support and resistance regions from previous days can be significant markets for future days when the price is moving sideways.

Calculating Volume-weighted Average Price

The volume-weighted average price (VWAP) is a technical indicator that helps retail investors understand the market. It is calculated using a mathematical formula, starting with the opening bell and ending with the closing bell. 

The formula is 

VWAP = Cumulative Typical Price*Volume/Cumulative Volume = Cumulative TP*V/CV. 

The typical price is the average of the high, low, and closing prices of the asset, while the cumulative volume refers to the total volume since the trading session opened. The Cumulative Volume (CV) represents the total volume since the trading session opened, while Volume represents the volume traded at a particular point. The VWAP indicator on a price chart results in a smooth curve, as shown in the diagram below. Understanding how to calculate the VWAP is crucial for retail investors.

Conclusion

Volume-weighted average price is an important tool, especially for technical traders. You can base your trades on the indication or create additional strategies around it. However, keep in mind that you must continue to adhere to strict risk management measures. Regardless of the signal, there is always the possibility that the deal may not go as planned.