What is VWAP Strategy

Volume weighted average price (VWAP) is a useful technical indicator for investors and traders to estimate the average price at which any security has traded throughout each day. VWAP was introduced around the 1980s and is the brainchild of Kyle Krehbiel. The VWAP indicator is important since it considers both volume and prices, thereby helping traders identify a security’s true market value. 

Over the years, several versions of VWAP have emerged. One of these is the anchored VWAP. This calculates the average security price that is weighted by volume, beginning from the anchor or particular point on the chart instead of the start of the trading session. It helps traders get better insights into prevailing market conditions. Let us learn more about it here. 

How to Calculate VWAP

Now that you know the meaning of VWAP, it’s time to take a look at the calculation process. The following is the formula for VWAP: 

VWAP = ∑ (Price × Volume) / ∑ Volume

Here, the numerator indicates the total value of all the trades for any specific period, and the denominator indicates the total trading volume for the same duration. It is usually shown as a single line plotted on the chart and moves simultaneously with the price movement of any security. Whenever the price goes above the VWAP line, it means that the security is trading at a higher price relative to the average. A price below the line indicates that the security is trading at a price that is lower than the average. 

Here’s how to calculate anchored VWAP: 

The formula is the same as the standard one: 

Anchored VWAP = ∑ (Price × Volume) / ∑ Volume

Yet, the difference is that the starting point is anchored to a particular event/date, such as a major news release or earnings announcement. It is a variation enabling traders to set any particular anchor or starting point for the VWAP calculation. 

VWAP as Support & Resistance

Using the anchored VWAP calculation is a good way to identify the major support and resistance levels based on volume and historical price data. VWAP can thus be a more dynamic support and resistance level, where the price of the security may reverse direction or bounce off. This makes it a vital risk management tool for trading purposes since securities consistently trading below/above the VWAP line may indicate consistent downtrend/uptrend patterns. Also, deviations from the same may be used to swiftly identify mean reversion opportunities, with the assumption that prices usually revert to their averages over time. 

Entry & Exit Strategies using VWAP

Chalking out your VWAP trading strategy largely revolves around determining the right entry and exit points. Here are some key points worth noting in this regard: 

• You may enter a long position when the price breaks over the VWAP line, indicating an uptrend. A short position may be entered when the price breaks below the line, thereby signaling a downtrend. 
• You can thus enter long positions whenever the price bounces off from the line or short positions when it slips down from above. 
• Another option is to use moving average crossovers with VWAP for potential exit or entry points. For instance, a long position may be viable whenever the short-term moving average is seen to cross above the VWAP line. Conversely, a short position may be feasible whenever the short-term moving average crosses below this line. 

VWAP for Day Traders vs. Institutions 

After understanding the meaning of VWAP in the stock market, it’s time to look at its relevance for day traders vis-à-vis institutional players. The latter often use it as a benchmark for executing larger orders to lower the market impact of these trades. The same holds true for mutual funds as well, whenever they enter or exit various stocks. They will usually try to buy stocks below the VWAP line while selling them above the same. Thus, it will result in the price being pushed back towards its average instead of going further away from it. 

Day traders also depend on VWAP, taking long positions if the stock prices move above the latter and initiating short positions/selling their positions if they fall below the line. 

Real-World Examples

To understand the definition of VWAP, here is an example that may help. 

VWAP = (Cumulative (Price*Volume) ÷ (Cumulative Volume)

Let’s assume that the high, low, and closing prices are ₹25, ₹20, and ₹23, respectively. In this scenario, the price calculation will be done as follows:

[(25+20+23)/3]- which is 22.67. 

The next step is multiplying this figure by the day’s volume. For example, if the volume is 25, then the result will be 22.67*25 = 566.75. 

You may also track the cumulative volume by adding up the volume while it aggregates throughout the whole day. If this is 80, then the formula [(typical price * volume) / cumulative volume] may be used as – 566.75/80 - 7.08. 

Key Takeaways:

• You may compute this for each data point related to each period. The results are then shown as a line on the chart. 
• It can be a tool for confirming a trend and then building a trading strategy based on the same. Institutional players also look at using it for lowering market impact.
• Determining a bearish or bullish market is possible with the VWAP (when the price is above it or below it), enabling better trading decisions. 
• Investors can wait for better prices to enter the market and, if they are buying stocks below the VWAP line, will avoid paying more than the average price of the same. 
• Identifying chances to purchase stocks at lower prices and potentially earn better profits while selling them. 
• It could be a better option than moving averages since it represents the true average price of any stock more accurately. This is because the volume of shares traded at every price point is taken into consideration, with higher weightage for prices with higher trading volumes. 
• Hence, the VWAP is not as affected by extreme movements in prices or trading volumes that are abnormally large/small. 

Conclusion

The VWAP indicator can be used for gauging market sentiments without being impacted by extreme price fluctuations or other sudden events. This is because of the unique formula, which takes share volumes traded at each price point into consideration (with more weightage given to prices that have higher trading volumes). VWAP enables investors to make more informed decisions while helping identify opportunities to buy low and sell at a profit or enter at more favourable market prices.