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How does the VWAP work, and what are its limitations?

How does the VWAP work, and what are its limitations?
Asked by
Benjamin Schmitz time-icon1 month ago
1 Answer Answer Question

Sheila Olson
Answered time-icon1 month ago

The volume-weighted average price (VWAP) indicator is a unique type of price average that tracks changes in price in relation to volume on intraday charts. The VWAP only works on charts with timeframes that are lower than the daily timeframe where it tracks the average price at which an asset traded over a chosen intraday period. The VWAP is plotted as a line on the price chart in a similar way to how the typical moving average indicators are drawn, but it is calculated in a very different manner compared to the MAs.

Chart 1: The VWAP indicator on the GBP/JPY 1-hour chart

 

How to calculate the VWAP

The VWAP is calculated by taking the average price at which a stock traded over a given period and multiplying it by the volume (total number of shares traded) to get the PV value. The average price is calculated by adding the highest, lowest and closing price for the affected period. Then, you must sum up all the PV values and divide by the sum of the volume of shares traded for each period. These calculations are represented by the formula below:

VWAP = Sum of (P * V) values

Sum of V values

This means that the VWAP is calculated by dividing the cumulative values of PV by V. Luckily, you do not have to do these calculations manually as the VWAP indicator is typically included in most charting platforms.

 

How the VWAP is used by institutional traders

The VWAP is used by large financial institutions such as hedge funds and mutual funds to time their trade entries to ensure that they have the smallest possible impact on the asset’s price.

This is largely because most institutions typically trade positions worth millions of dollars in any asset they buy, which could see the price move either higher or lower as they execute their trades.

Therefore, in most cases, institutional players will aim to buy a stock when the price is below the VWAP and sell a stock when the price is above the VWAP. That way, their trades will push the price in their favour as their large orders are filled.

 

VWAP trading strategies used by retail traders

As a retail trader, you can use the VWAP to either trade pullbacks, breakouts, or touches depending on your risk appetite. Aggressive day traders may look to trade a unique type of pullback depending on the overall trend, as demonstrated by the bullish trade signals below.

Chart 2: Bullish trade setups for aggressive traders

Aggressive day traders may find the above trade signals quite lucrative in the sense that the overall trend is bullish. The trade signals are generated when price breaks below the VWAP indicator and then pulls back in the direction of the pre-existing bullish trend.

Two of the entries above appear to be counter-trend trades but could have generated significant profits for aggressive traders who took the trades. This is just one of several ways in which retail day traders can use the VWAP. We’ll go deeper into this and other trading strategies in a different article.

 

Why the VWAP is different from the SMA

The main difference between the VWAP and the simple moving average (SMA) can be found in how they are calculated. The VWAP is calculated from the average price and the volume traded over a set period.

The SMA is simply calculated from the closing price over a set number of periods and does not include the highest and lowest prices and the volume.

Another distinguishing characteristic between the two indicators is that the VWAP only works on intra-day time frames, while the SMA works on all time frames from the intraday charts to the daily, weekly and monthly charts.

 

Limitations associated with the VWAP

The fact that the VWAP only works on intraday charts is a major limitation for most swing and position traders. Price does not always respect the VWAP, which means that it may keep moving higher and might never pull back or cross below the indicator, resulting in missed trade opportunities.

 

The bottom line

The VWAP is an excellent intraday indicator that is popular among both conservative and aggressive day traders. It is calculated in a different manner to the SMA, but both are used in a similar manner. You should combine the VWAP with other trading tools to manage your risk exposure.

 

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