The volume-weighted average price (VWAP) is a statistic used by traders to determine what the average price is based on both price and volume. Whether a price is above or below the VWAP can offer valuable insights for traders. In this article, we will delve into the details of VWAP, its calculation, its applications, and how it differs from a simple moving average (SMA).
What Is the Volume-Weighted Average Price (VWAP)?
The volume-weighted average price (VWAP) is a technical analysis indicator utilized on intraday charts. It resets at the beginning of each new trading session, offering traders a comprehensive view of a security's average trading price throughout the day. Unlike a simple moving average, VWAP considers both price and volume in its calculation, making it a valuable tool for traders seeking insights into intraday price trends and value assessment.
Understanding the Volume-Weighted Average Price (VWAP)
The VWAP is calculated using the following formula:
VWAP = Cumulative Typical Price x Volume / Cumulative Volume
Where:
- Typical Price is determined as (High price + Low price + Closing Price) / 3.
- Cumulative refers to the total since the trading session opened.
To calculate VWAP manually, especially on intraday charts, follow these steps:
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Find the average price of the stock traded during the first five-minute period of the day. This is achieved by adding the high, low, and closing prices and dividing by three. Then, multiply this value by the volume for that period and record it under the column PV in a spreadsheet.
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Divide PV by the volume for that period to obtain the VWAP for that interval.
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To maintain the VWAP throughout the day, add the PV value from each period to the prior values and divide this total by the cumulative volume up to that point. Creating columns for cumulative PV and cumulative volume in a spreadsheet can simplify this process.
How Is VWAP Used?
Traders employ VWAP in various ways:
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Trend Confirmation: Traders consider stocks with prices below VWAP as undervalued and those above it as overvalued. A move from below to above VWAP might prompt traders to go long on the stock, while the reverse could lead to selling or initiating short positions.
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Institutional Strategy: Institutional buyers, like mutual funds, use VWAP to execute large orders with minimal market impact. They aim to buy below VWAP and sell above it, keeping prices close to the average to avoid affecting market dynamics.
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Assessing Trading Activity: VWAP's integration of volume provides insight into trading activity during short timeframes, indicating whether competitors are entering or exiting positions.
The Difference Between VWAP and a Simple Moving Average
While VWAP and a simple moving average (SMA) might appear similar on a chart, they have distinct differences:
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VWAP is calculated by considering both price and volume, whereas SMA only uses price data.
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VWAP is a single-day indicator that resets at the beginning of each trading session. In contrast, SMA calculates the average closing price over a specified period (e.g., 10 days) without considering volume.
Limitations of VWAP
It's important to acknowledge the limitations of VWAP:
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VWAP is a single-day indicator and can't provide insights into longer-term trends.
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Waiting for a security's price to fall below VWAP in strong uptrends could result in missed opportunities.
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VWAP's calculation relies on historical data and lacks predictive qualities.
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As the trading day progresses, VWAP may lag, resembling a longer-term moving average.
In summary, the volume-weighted average price (VWAP) is a valuable tool for traders, offering insights into intraday price trends and trading activity. It distinguishes itself from a simple moving average by incorporating both price and volume data. Traders can use VWAP to confirm trends, develop trading strategies, and manage large institutional orders effectively. However, it's essential to recognize its limitations and use it in conjunction with other indicators for a comprehensive trading approach.
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