Where’s the momentum? Put the VWAP to the test
The Volume Weighted Average Price (VWAP) indicates the average price of a volume weighted intraday period. The value is calculated during the trading day, from open to close, making it a dynamic indicator in real time.
Photo by TD Ameritrade
Key points to remember
Volume Weighted Average Price (VWAP) can be used to help identify liquidity at specific prices during the trading day
VWAP can be used to identify price action based on volume at a particular time period during the trading day
Indents and breaks from the VWAP can be helpful in identifying potential entry and exit points
Just as an airplane needs thrust to gain speed and take off, so does inventory. Stocks need momentum or liquidity to pump them up and get them to move. And traders, especially short-term ones, can potentially benefit from trading stocks with momentum. But how do you find this momentum? Be prepared to spend time watching the price move – know when to pay attention and when to take a break.
It’s a no-brainer: Volume boosts momentum, which is why most chartists keep an eye on volume regardless of which indicator they use. Some prefer to add sub-graphs of volume based indicators such as accumulation / distribution or balance sheet volume (OBV). A volume-based indicator, the Volume Weighted Average Price (VWAP), combines price action and volume on the price chart. One glance and you can get an idea of ââwhether buyers or sellers are in control at a specific time.
Another value-added feature of the VWAP is that it is calculated from the opening of the market until it is closed. In other words, you can see the price and volume action unfold in real time at a specific point in the trading day. This can be invaluable information for short term traders.
What is Volume Weighted Average Price (VWAP)?
The VWAP is the average price of a stock weighted by volume. What does this really mean? By monitoring the VWAP, you might get a feel for the liquidity and price that buyers and sellers agree to be fair at a specific time. The VWAP indicator is often used by day traders to understand intraday price movements. Institutions and algorithms use it to determine the average price of large orders.
How is the VWAP calculated?
The formula is simple in that it is a running total of the price of each trade, multiplied by the volume of that trade, divided by the total volume traded for the day.
Want to know the formula?
On the thinkorswimÂ® platform, the VWAP is calculated using this formula, where the size is the volume traded at the price:
But you don’t necessarily need to know the formula. You can plot the indicator on thinkorswim charts. From Graphics tab, add a symbol and display an intraday chart (see Figure 1). To select Studies, and in the drop-down menu, select Add a study > Market strength studies > VWAP.
The VWAP is displayed as a line, similar to a moving average. On the chart, it is the purple line that crosses the prices. Remember the VWAP is an average, which means it’s overdue. Typically, when the VWAP goes up, it indicates that prices are going up, and when it goes down, prices may tend to go down. And, like a moving average, you can use the VWAP as a benchmark to help you make entry and exit decisions. In thinkorswim you will notice two bands–one above and one below the VWAP. These bands, displayed on an intraday chart, correspond to a specified number of standard deviations above and below the VWAP. Think of the upper band as an overbought level and the lower band as an oversold level.
VWAP Trading: How To Use It
Stocks generally go through periods of trends or consolidations. They often consolidate for a while and then turn into an uptrend or a downtrend.
One way to understand VWAP is to watch the price action as you approach a significant line on the chart. In Figure 1 you see that before the opening there is a price consolidation. The VWAP is relatively flat or low momentum. When the markets opened up momentum increased and in this case the price moved below the VWAP and approached the lower band but didn’t quite hit that lower band. The price rallied, passed the VWAP, and hit the upper band, which acted as a significant resistance level. Do you see how the price bar broke above the upper band and then quickly returned to the VWAP? It stayed there for a few bars, i.e. the support level, but then broke below and moved to the lower band.
This time it hit the lower band, went under it, and then started to move up. After a few measurements, he tests the lower band again. He then climbed back up to the VWAP and sort of settled there for a little while. This suggests that the momentum could slow down.
In the afternoon trading, prices started to move back down to the lower band and stayed there for a while. The lower band served as the support level and the VWAP as the resistance level.
It doesn’t always have to be. Sometimes VWAP can be the support level and the upper band the resistance level – it all depends on market action.
About two hours before the close, momentum started to pick up, with prices gravitating towards the lower band, sometimes exceeding it. During the last hour of trading, you might see prices move above the lower band. But the markets are on the verge of closing, and the slight decline in the VWAP suggests a downtrend and lower volume. Momentum picks up after the market closes.
Watching price action gives you an indication of buying or selling activity. Suppose the price goes below the VWAP and, within a few bars, closes above. This could mean that buying activity has picked up and price could move to the upper band. In this case, you can consider a long position and place a stop loss order below a previous low point. Your exit target can be any strategy such as a previous higher, upper band, or any other technical indicator. As with most indicators, the VWAP can be more effective when combined with another indicator such as the Relative Strength Index (RSI) or moving averages.
The VWAP is a dynamic indicator calculated for a trading day. But that doesn’t mean you can’t use VWAP for longer periods of time. On a daily chart, you can just see the VWAP line (see Figure 2), which you can use to identify price trends and reversals. Since the line goes through each price bar, you can determine whether the going price is higher or lower than the VWAP.
The VWAP calculation for the day ends when trading stops. At the next opening, a new VWAP begins, unrelated to what happened the day before.