Justin is an active trader with more than 20-years of industry experience. He has worked at big banks and hedge funds including Citigroup, D. E. Shaw and Millennium Capital Management.
VWAP trading strategies help active traders identify trade entry and exit points by using data relating to the amount of an asset traded, not just the prices recorded. By factoring in both elements, VWAP reflects at what price levels buyers and sellers are fighting about the direction the market should take. By breaking down a single trading session into time intervals, such as each five minutes, it’s possible to better understand the sentiment in the market.
Volume Weighted Average Price strategies are intra-day trading strategies that are very popular with day-traders. Most of the VWAP style activity occurs at institutional investment houses such as hedge funds and investment banks. So not only does understanding VWAP offer the opportunity to spot trading signals and make a profit over a short time frame, but it also sheds light on where the big money is heading.
In this article, we'll use real-life trade examples to look through:
Most retail traders have little concern about moving market price each time they trade, but it is potentially a significant concern for big institutional investors.
Take, for example, a hedge fund that wants to sell out of a stock where it has a position that is a substantial percentage of the total market cap of the firm. If daily trading volumes in that market aren't of sufficient size, then each time they try to sell, they'll run the risk of driving the price down, which is obviously not something they'd want. This means that orders need to be ‘worked' with the position sold in smaller pieces over a time frame which doesn't lead to self-defeating price moves.
The same principles apply for funds looking to build larger positions, and VWAP is a metric these big investors use to ensure they aren't overwhelming the rest of the market. If they are buying, they want to do so at a price lower than VWAP and vice versa for sell programs.
Hedge funds aren't in the habit of sharing details on how their trading floors are structured, but a portfolio manager at a big fund will stick to their role as the ‘ideas guy' having a trader on their desk or by using the firm's dedicated trading desk, to execute their orders.
The trader or trading desk will focus on one thing, getting as good a price as possible, and the measure used to gauge how successful they are at doing this is VWAP. Their trading day starts at market open and finishes at market close. There may be orders left to work the next day, but they are effectively day traders looking to optimise trading profits by selling and buying at intraday highs and lows.
Not all portfolios have hands-on human fund managers making the big calls. Those that use systematic trading models and pre-programmed algorithms account for an ever-increasing amount of market flow, and many use VWAP as part of their strategies. Some trend-following programs will look for breakouts in price, and some arbitrage-based models will look to trade the daily price range if the market moves sideways.
VWAP ultimately boils down to a mathematical formula. The highest-level summary description describes VWAP as the ratio of an asset's average price compared to the volume of trades in that asset over a particular time frame. Breaking out the formula used to calculate VWAP using numbers can help explain the mechanics of the process.
The calculation starts by taking the price of an asset at the opening of the trading session. If using five-minute candles, the high and low price of that five minutes of trading is used in conjunction with the closing price. If the exchange opens at 8.00, then VWAP uses the highest and lowest prices printed between 8.00–8.05 and the closing price at 8.05 and calculates the average Typical Price (TP) by dividing the total of those by three.
The below chart shows the price action of BARC shares traded on the LSE where 183.82 + 182.96 + 182.96 / 3 = 183.2467 = TP
The volume of shares traded in that time interval was 28,000 and this is multiplied by the Typical Price to give the Total Price Volume (TPV). So:
The next five-minute candle for the period 8.05–8.10 incorporates the TPV for both periods. This is expressed as:
[TPV Candle 1 + TPV Candle 2] / [Volume Candle 1 = Volume Candle 2]
Where Candle 1: 8.00–8.05 and Candle 2: 8.05–8.10
The formula breakdown highlights why some analysts perceive VWAP as a better gauge of ‘real' price than a simple mean average of high, low and closing prices. A lot of buying and selling activity at a particular level is reflected in the VWAP but not a simple mean average formula.
Fortunately, analysts and traders can set up accounts with brokers that have charting packages allowing VWAP to be calculated and overlayed onto any price chart. The blue line on the above price chart for Barclays' stock shows the VWAP, and the red cross marks the number at 8.10.
Note: Time intervals are set at traders' discretion and can include periods other than five minutes, but VWAP only uses intraday data, so it can only be used for intraday trading strategies.
The Dow Jones Industrial Average time interval has been set to five-minute candles in the above price chart. Calculating VWAP using five-minute intervals creates the blue line, and it's possible to see that market mood can only be described as bullish. At each point, that price drops close to the blue line but soon spikes upwards again. Traders are left with the option of buying anything that looks like a dip or waiting for market sentiment to turn bearish and potentially missing out on the move altogether.
A secondary confirmation is provided by the number of consecutive green candles that form the breakout above the VWAP line. The seven five-minute candles on the left-hand side of the chart represent 35 minutes of buyers overpowering sellers. Such additional indicators are always welcome and, in this instance, give a good indication of which way the market is heading.
While market conditions are bullish, there are periods throughout the trading session when price moves to levels where it is no longer supported. Then a natural fall in buying activity causes price to fall back down again. These become potential trade exit points for day-traders and an opportunity for more active traders to trade the regression and sell short.
It's possible by using the chart below to see that any long-only traders who bought the dips, the green arrows when price fell back to the VWAP level, would have made a profit. Those who had bought also sold, or sold short, at the red crosses would have enhanced their returns.
While market price is trading above the VWAP, the trend is confirmed. However, in our example, the last red candle on the below chart has breached the VWAP line leaving traders with a decision to make about whether the trend has come to an end or not?
If the market is turning bearish, then a reverse approach would be required. That would involve using the VWAP as a resistance level and selling short at times live prices traded near to it. In this instance, we've seen only one candle break the VWAP line, so it's possibly too early to tell if the trend is reversing or not. That raises the question of how to trade using VWAP in markets that aren't trending in one direction or another.
In directional markets where momentum has signalled a breakout trading pattern, VWAP can be used as a support or resistance line. In sideways trading markets and the absence of a breakout, price can be expected to trade either side of VWAP and revert to it as a mean average of that day's trading. In this scenario, the institutional investors can be expected to be buying when price is below the VWAP and selling when it is above. The balance provided by sellers and buyers matching each other in relatively equal measure creates trading opportunities caused by the churning nature of price movement.
The primary factor working against VWAP is that it is a lagging indicator. It gives insight into where ‘real' trading took place, but it still looks backwards rather than forwards. This is a feature of many technical analysis tools, so VWAP is not alone in being criticised for this. There are, however, other features of VWAP which need to be considered.
The cumulative nature of the VWAP formula and the fact that it starts each trading session afresh means that there is some confusion caused right after markets open. There's not enough recent data to provide a clear steer on market direction. After all, any market momentum can only be confirmed once price starts to move away from VWAP.
The first candle is particularly weak as it has no prior candle to refer to, and during the first few intervals, it can often be the case that price candles overlap VWAP. In the above price chart, six of the first seven candles intersect VWAP at some point during the five minutes. The notable move occurs close to 9.00hrs when price breaks above VWAP and holds a price level some way above it.
There is also the issue of market open (and market close) being associated with higher trading volumes. Combined, these factors make it hard for analysts to identify the trend and establish whether VWAP will act as a support, resistance, or if the day's trading will follow a sideways pattern.
One popular strategy is to use five-minute intervals and look for signs of a market trend building 15 minutes after market open. If that is the case, it could indicate a big institutional investor building into a position. Such activity can carry on through the day, meaning the buying or selling activity of that ‘real' money could be something to tag along with. If momentum fizzles out, then it could be a day to trade a different market where there is some momentum or alternatively try to scalp price moves in a sideways market.
One crucial factor to consider is the benefits of combining signals from a range of different indicators. VWAP is helpful, but a buy or sell signal confirmed by another indicator such as moving averages or relative strength index will have a higher probability of being correct.
In the above five-minute price chart for Barclays, the RSI reaches a low of the day just before price rebounding. While the 30 RSI level wasn't quite clipped, the signal that BARC was oversold on a short-term time frame coincided with a break of VWAP 10 minutes later. Used in conjunction, these two indicators provided a more reliable indication of what might be a good trade entry point for a long position.
As some of the definitions of market terms are circuitous in nature, it's possible to flip things around and define a sideways trading, or range-bound, trading day as one where price frequently trades above and below VWAP. A day of bullish momentum would be defined as one with price trading above VWAP and a bearish one a day when price trades below it. VWAP can be used to gain an understanding of the market as much as it can be used to identify trade entry and exit points.
In terms of being a trading signal, VWAP is held back by being a lagging indicator. It's also not suitable for trading the opening bars of a trading session and is of limited use to those investing over a medium or long-term time frame. It does, though, take understanding to another level and offer a look through to what big funds might be doing in the market. There are also plenty of day-traders who use VWAP to navigate the intraday markets successfully.
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