The popularity of VWAP can be attributed to the fact that it incorporates the volume of trading activity at different price levels rather than just reporting price alone. That means it offers a different and deeper insight into the stock markets than metrics such as simple moving averages (SMAs), which only use price data. Let’s explore further in the article that follows.
What is the Volume-Weighted Average Price of a Stock?
VWAP is a measure of a security’s price over a period of time. It reflects not only the different price levels at which stock trades were made but also how much trading activity was conducted at those different levels. This enables VWAP to show where the ‘real’ trading went on.
A trader watching their monitors might notice how the price of stock ‘ABC’ moves from $1.00 to $1.05. However, if 200,000 shares have so far in that session been traded at $1.00, and the trade at $1.05 involves only 200 shares, then the trade at the higher price is an outlier and gives less of a clue as to the real mood of the market.
VWAP incorporates trade volumes as well as price history, and that allows traders to decipher that the $1.00 price level is the one that most traders at that time see as being closer to fair value. In our example, although the price chart and SMAs will reflect the move from $1.00 to $1.05, the VWAP reading considers trade volumes – so the level will be much closer to $1.00. Given the underlying market conditions, this intuitively appears more accurate.
Stock VWAP calculations work on a daily basis. They commence at the start of a daily trading session and finish at the market close. In the case of the London Stock Exchange, this would be from 8am–4.30pm. Another feature of stock VWAP readings is that, unlike some other indicators, they don’t carry on overnight.
The nature of VWAP makes it a tool that is useful to short-term speculators and day-traders looking to profit from spotting intra-day pricing anomalies. It is also used by large institutions that want to trade sizeable stock positions without flooding the market and moving price against them.
How to Calculate VWAP
VWAP is calculated by taking the total consideration of every trade (the amount of dollars traded) and dividing that number by total shares traded.
VWAP = (Number of shares bought x Price those shares were bought at)
/ Total shares bought that day.
Standard VWAP is reflected as a single number – the VWAP of that day’s trading session, which will fluctuate during the course of the session. It can also be expressed as a line on a price chart by breaking the whole day into smaller time frames.
Taking the VWAP for each 15 minutes of trading, for example, and logging each individual reading allows for a trend line to be drawn, one that connects the different VWAP readings for each 15 minute interval. Of course, online platforms have algorithms that perform these functions for traders, which makes VWAP an even more user-friendly tool.
How to Use VWAP?
VWAP gives a simple and instant guide to whether a stock price can be considered to be over or undervalued. In the simplest terms, if the price is above VWAP, then it is overvalued. At that period of the trading session, buyers are in the ascendency. If the market price is below VWAP, the opposite is the case.
Interpreting that data is the tricky bit. If price is above VWAP, that could be a sign that it is due to weaken and revert to the average. Alternatively, it could be a sign that momentum is building, and a news development or new fundamental analysis suggests the stock could be about to break out of its current trading range.
For that reason, VWAP is often used in conjunction with other technical indicators. The more indicators that point in the same direction, the stronger the overall signal. The way that VWAP allows traders to look into the flow in the market makes it an important tool for traders who are looking to buy or sell significant stock positions.
Take, for example, a pension fund or systematic hedge fund that is looking to buy a large number of shares – such as a number that equates to more than half the average daily trade volume. If a trader tried to buy the position too quickly, they could hit the offer price given by sellers and drive the market price higher. That’s bad news, as, then, further purchases would be more costly.
Applying a patient approach is therefore recommended, and our buyer will usually consider it ‘safe’ to build on their positions whenever market price is below the daily VWAP.
Pros and Cons of Using VWAP to Trade Stocks
VWAP is a straightforward and intuitive measure of market conditions
Specifically, this applies at the price at which most trades are getting done. Getting into the granular details of how the VWAP is calculated can help a trader understand the mechanics of the process, but online brokers offer it as an automated trade indicator, so it’s easy to find and use.
VWAP tends to be less volatile than SMAs, which means there is less ‘noise’. It’s also user-friendly. The time frame parameters, which were in our example above, were set to 15 minutes – these can also be adjusted according to trader preference.
VWAP only covers one trading session
The major drawback of VWAP in terms of stock trading is that it only covers one trading session. Each day, the readings begin again when the exchange reopens. Short-term metrics are ideal for short-term strategies. Those scalping stocks or following equity arbitrage strategies will be very aware of where VWAP is and incorporate it into their trading activity.
However, buy-and-hold investors and those running longer-term strategies have less use for VWAP, though they could still use it to try and optimise their trade entry point and pick the best time of the day to trade.
VWAP and Stock Market Trading Patterns
The time periods after a stock exchange opens and before it closes are associated with intense trading activity as investors scramble to get into and out of positions. As a result, a large proportion of the daily trade volume will be seen during the first and last 30 minutes of each session.
The rest of a typical stock market trading session can be relatively quiet unless there is a major news announcement. This makes VWAP, in some ways, even more important.
Any price moves during the quieter times of day – for example, the lunchtime session – won’t fool traders who use VWAP from knowing where the majority of the market thinks the true value is. Should a stock price momentarily spike or crash during a time of low volume, the VWAP will provide a more realistic guide to that day’s market conditions.
If you are looking to use VWAP and engage in short-term trading, then some thought would need to be given to the broker you choose to use. Speed of trade execution might be a higher priority and these reviews offer a breakdown of the pros and cons of respective brokers.
All of the brokers on this list of regulated brokers offer markets in stocks and some offer additional services such as specialist research or technical indicators designed to complement VWAP-based strategies.