Volume Weighted Average Price (VWAP)
- 22 Feb 2024
- By: BlinkX Research Team
Traders and investors in financial markets are always seeking tools to assist them make educated purchasing and selling choices. Volume Weighted Average Price (VWAP) has been a prominent technique in recent years. A VWAP is an algorithm that calculates the average price an asset has traded in a given day, weighted by the number of trades. It is often utilised by institutional traders to execute huge orders with minimal market impact.
By knowing how VWAP works and how to apply it, traders may get a competitive advantage in the markets and make better trading decisions. Let us discuss what is VWAP in share market, the definition, usefulness, and limitations of Volume Weighted Average Price.
Understanding VWAP Meaning
The Volume Weighted Average Price (VWAP) is a technical analysis indicator that measures the average price at which a certain securities trades over a specified period. Unlike conventional moving averages, which compute an 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 commonly used by institutional traders who need to execute big orders over a day or more. By comparing their performance to the VWAP, users may decide if their transactions were performed at a beneficial price or not. VWAP is also useful for spotting possible support and resistance levels, as well as trend reversals.
Table of Content
- Understanding VWAP Meaning
- How to Calculate VWAP
- How Is VWAP Used?
- Pros and Cons of VWAP
- Difference Between VWAP and a Simple Moving Average
- Limitations of VWAP
How to Calculate VWAP
After understanding what is volume weighted average price, let's get into its calculation. VWAP (volume weighted average price) is generated daily using intraday data that begins with the market's opening and ends with its closing time. The Volume Weighted Average Price formula:
VWAP = (Cumulative Typical Price * Volume) ÷ (Cumulative Volume)
Example:
In the equation above, the normal price is the average of the high, low, and closing prices. You may compute it using the following formula:
Cumulative Typical Price (TP) = high price + low price + closing price/three.
Let's have a look at an example to help you grasp the computation. Let us imagine that the maximum price is 20, the low price is 10, and the average closing price is 15. Using the standard pricing calculation, we get TP = 20+10+15/3 = 15.
Then, multiply the TP by the volume. Assume the volume of the period is (V) = 20. Thus, TP*V equals 300. Cumulative volume for the stock, which in this case is assumed to be = 75.
So, VWAP = TP*V/CV = 300/75 = 4
The VWAP may be calculated for each period, resulting in the creation of a curve on the price chart.
How Is VWAP Used?
Traders utilise VWAP in a variety of ways to inform their decision-making. One method is to use VWAP as a tool to confirm trends and then construct trading rules based on them. For example, if a stock's price is less than its VWAP, traders may regard it as undervalued, and if it is more than VWAP, they may consider it overpriced. If a stock's price rises over VWAP, traders may go long; if it falls below VWAP, they may sell their shares or establish short ones.
VWAP is frequently used by institutional purchasers, such as mutual funds, to lessen the market effect of their stock purchases and sales. As a result, they will try to buy stocks below the VWAP and sell them above it. As a result, their activities assist in pushing the price closer to the average rather than away from it.
Pros and Cons of VWAP
Here are the pros and cons of VWAP:
Pros of VWAP | Cons of VWAP |
Used in algorithmic trading to find optimal buy/sell | Cumulative indicator, based on a large data set |
This can lead to cheaper transaction costs and better execution | Potential for lag in VWAP line |
Useful for trading large volumes of shares | Employing shorter periods (1-5 minutes) can mitigate lagging issues |
Helps avoid artificially inflating the price of a stock | - |
Difference Between VWAP and a Simple Moving Average
The Volume Weighted Average Price (VWAP) and a simple moving average (SMA) are two technical analysis indicators that may be used to determine a security's average price over a specific period. However, there is a significant difference between the two. While a SMA generates an average price based solely on time, VWAP considers both price and volume of trades. This implies that the price of larger trades has a higher impact on the VWAP than smaller deals. As a result, VWAP can give a more accurate picture of a security's genuine average price, especially when trading in huge quantities.
Limitations of VWAP
The VWAP indicator is intended to be used daily and resets at the start of each trading day. Attempting to determine an average VWAP across many days might result in mistakes and distortions.
While some institutions may purchase below or sell above the VWAP, it is also crucial to evaluate other aspects. In a strong uptrend, the price may continue to increase without falling below the VWAP, therefore waiting for a dip below it may result in lost chances.
VWAP is a historical indicator that lacks forecasting capabilities and computations. It is related to the day's beginning price range, and its lag grows longer as the trading day unfolds. For example, a one-minute VWAP calculation after 330 minutes of trade may approximate a 390-minute moving average after the trading day.
Conclusion
The Volume Weighted Average Price (VWAP) is a trading algorithm that determines the average price at which a securities has traded during the day, weighted by the volume of each deal. By knowing how VWAP works and how to apply it, traders may get a competitive advantage in the markets and make better trading decisions. Finally, everyone should invest with a reliable stock market app.