What is VWAP?
Volume-Weighted Average Price (VWAP) is a trading indicator that shows the average price a security has traded at throughout the day, based on both volume and price. It is calculated by adding up the dollars traded for every transaction (price multiplied by number of shares traded) and then dividing by the total shares traded for the day. VWAP is often used as a benchmark for the performance of an asset or portfolio, as it represents the average price at which the asset has traded over a specific time period.
What is VWAP Formula
The formula for calculating the volume-weighted average price (VWAP) is as follows:
VWAP = (Sum of (Price * Number of shares traded)) / (Total shares traded)
To compute the VWAP, you need to multiply the trade price by the number of shares for each trade that occurs in the period, then sum those products and finally divide by the total shares traded for the period.
It’s worth noting that VWAP can be calculated for any period of time, although it’s more commonly used for intraday calculations. Also keep in mind that VWAP is only one of many indicators available to traders.
Why Do Traders Use VWAP
- Takes into account both price and volume: VWAP takes into account both the price at which a security is trading and the volume of shares being traded, which can provide a more accurate representation of the market’s sentiment towards the security. For example, a security that has a high VWAP but low volume may indicate that there is not much interest in the security, while a security with a high VWAP and high volume may indicate strong demand.
- Widely used by institutional traders: VWAP is a popular indicator among institutional traders and is often used in algorithms to execute large trades in a way that minimizes market impact. This can make it a useful reference point for traders looking to trade larger quantities of an asset.
- Can be used to identify trends and potential areas of support and resistance: Technical analysts may use VWAP as a way to identify trends and potential areas of support and resistance. For example, if a security is consistently trading above VWAP, it may be considered to be in an uptrend, while if it is consistently trading below VWAP, it may be considered to be in a downtrend.
How to Use VWAP in Trading
There are several ways that traders can use VWAP in their trading strategy. Some traders may use it as a trend-following indicator, buying when the security is trading above VWAP and selling when it is trading below. Others may use it as a reference point to scale into or out of positions, buying or selling smaller quantities as the security approaches or moves away from VWAP. Some traders consider it as a magnet for the price action. Saying goes, all stocks go back to VWAP.
What Are The Limitations of VWAP
Some limitations of using VWAP as a trading benchmark include:
- It only considers price and volume during a specific time period, and does not take into account other factors that may affect the security’s value.
- It can be affected by large trades or block trades, which can skew the average price.
- It only provides a historical reference and does not predict future prices or market trends.
- VWAP is calculated based on the traded volume, So in case of low liquidity or low volume it’s not very reliable.
- It is based on the assumption that all participants trade on the same side of the market, which is not always the case.
It’s important to note, however, that VWAP should not be used in isolation. Technical and fundamental analysis, as well as other indicators and market conditions, should also be taken into consideration when making trading decisions.
In conclusion, the volume-weighted average price (VWAP) is a trading indicator that provides a measure of the average price of a security based on both volume and price. it is a useful tool particularly in short term inter-day trading.