VWAP is typically used to help youtrade intoand out of positions improved price levels. VWAP is the ratio of the value traded to total volume traded over a particular time period. It is a measure of the average price at which a stock is traded.
If you are looking to enter into a long position over the course of a day, then you’d be ‘buying the dips’ which can be thought of as buying when price is lower than the daily VWAP. As you could sell short, or at least take profits when price is above VWAP we begin to see how a sideways market creates the opportunity for profits to be made by trading around VWAP.
It’s worth considering the crucial implications of the market changing from ‘sideways’ to ‘trending’, or vice versa. Interpreting VWAP to be in essence a short-term moving average allows you to consider a ‘break out’ of price action as not only a signal that momentum is building but also, in what direction it is heading. Instead of trading the regression back towards VWAP, you would build a position into a momentum trade.
Of course the two strategies involve putting on completely different positions. If you were selling in a sideways market, you’d be buying in a trending one. Getting that wrong can clear out your account in next to no time which is why being able to identify whether a market is sideways, or trending is so crucial to your trading performance.
The trading strategy ‘Opening Range Breakout’seeks to profit from price action signals at market open. It’s a popular strategy among day traders looking to trade short term, specifically intra-day, momentum. Some traders use Technical Analysis and candlestick charts to identify breakout is occurring. The VWAP, and more specifically, a situation when short term price crosses VWAP, can also be used as an indicator of breakout. In practice you’d probably use both indicators in conjunction.
The below chart taken from Interactive Brokers shows: VWAP as a yellow line and price action as red and green candlesticks. The blue and purple lines are the high and low standard deviations range, respectively. Half way through today’s trading session we can see the market today has been moving sideways. Selling when price was above VWAP and buying when it was below would have been profitable. Trading a breakout strategy would have brought about significant losses.
Source: Interactive Brokers Demo Trading Platform 20181129
Getting down into the detail of the calculation we see the supporting text from this broker explains the exact details of their methodology:
“Intraday Volume Weighted Average Price
Tracks VWAP throughout the day and displays as a colored line linking VWAP values at varying times throughout the one-day period. By default, the line that tracks Intraday VWAP is bracketed within a high/low standard deviation range. The standard deviation is calculated for the same period as the VWAP, and the range can be adjusted by modifying the number of Standard Deviations within the settings of the Intraday VWAP.
Intraday VWAP is calculated as: VWAP=[sum (Volume_bar_i * Typical_price_i)]/sum(volume_bar_i) where i is the intraday bar number. If we use a 1 min daily bar chart, the calculation is made from the first minute with i=[1;N] where N is the last bar number of the chart, Typical_price_i = VWAP_on_bar_price_i => This is the VWAP we currently store and volume_bar_i is the volume for the bar i. If no volume is available for the product (i.e. for IND, CASH and CMDY), use 1 as volume for each bar.”
VWAP is a useful tool that allows opportunities to finesse entry and exit into positions. It is also a useful indicator for trading sideways and trending markets; unfortunately knowing which type of market you are in is the tricky bit.