Introduction

Technical indicators are an important part of analyzing financial markets. Some of them are designed to illustrate momentum such as the Relative Strength Index (RSI), StochRSI or MACD. Others can be used to find potential points of interest on a chart, such as Fibonacci retracement tools, parabolic reversals or Bollinger Bands.

But what are the most basic indicators? Without a doubt, it’s volume. Volume can be used as a tool to confirm trends, identify potential reversal points, and many other strategies.

VWAP combines volume with price action to create a practical and easy-to-use indicator. Traders can use VWAP as a tool to confirm trends, or as a tool to identify entry and exit points.

Next, we’ll take a closer look at what VWAP is, how it works, and how traders can incorporate it into their trading Strategy.

What is VWAP?

The full name of VWAP is "Volume Weighted Average Price". As the name suggests, it is the average price of an asset during a given period weighted by trading volume.

What makes VWAP an especially powerful indicator is the way it incorporates volume into the average price calculation. Some traders believe that volume is the most important indicator besides price action itself. What makes VWAP an especially useful tool for analysts and traders alike is that it combines these two important indicators into one.

VWAP can display the dominant trends in the market, as well as important liquidity areas.

If you want to learn more about some of the most useful technical indicators, please see "5 Basic Indicators Used in Technical Analysis".

How to calculate VWAP?

In most trading interfaces, you only need to select the indicator and the system can automatically complete the calculation for you. Regardless, it's helpful to understand the formula behind it so you can use it more effectively. So, how is VWAP calculated?

To calculate VWAP, we need to add the transaction value (price times volume) of each transaction and divide Based on total trading volume.

VWAP = ∑ (Typical Price * Volume) / ∑ Volume

where

Typical price = highest price + lowest price + closing price / 3

Let’s calculate the VWAP line of an asset within 5 minutes. We need to do the following:

1. First, we need to calculate the typical price of the K-line chart in the first 5 minutes . We add the high, low, and closing prices and divide by 3.

2. Multiply the typical price by the volume during that time period (in this case 5 minutes). We call this value n1 because it relates to the first measured period.

3. Divide n1 by the total trading volume before this period to get the VWAP value for the first 5 minutes of trading.

4. To calculate continuous VWAP values, we need to continue to add the new n value (n2, n3, n4…) is added to the previous value and then divided by the total volume up to this point in time.

Now we understand why VWAP is called Cumulative Indicator , because the values increase by successive additions.

What information can VWAP tell traders?

For investors interested in a more passive, longer-term investment style, VWAP can be used as a benchmark for the current market outlook. A simple strategy might be to only buy assets below the VWAP line, which indicates that they may be undervalued.

That said, some traders may use price crossing the VWAP line as a signal to enter a trade. If the price breaks above VWAP, they may enter a long position. Conversely, if the price breaks below VWAP, they may enter a short position.

In this sense, VWAP acts like a moving average. When the price is above the VWAP line, the market may be interpreted as bullish. At the same time, if the price falls below the VWAP line, the market may turn bearish. Of course, this depends heavily on the context of the technology model and should be viewed with caution.

VWAP can also be used to identify areas of liquidity. This is especially useful for institutional traders who want to fill large orders. This indicator helps them identify ideal entry and exit points for large trades, thereby reducing their impact on the market.

VWAP can also be used to measure the efficiency of transaction execution. In this sense, buy orders executed below the VWAP are considered good trades because they are below the volume-weighted average price of the asset. Conversely, buy orders executed above the VWAP are considered bad trades because they are above the volume-weighted average price of the asset.

If large traders buy below VWAP and sell above VWAP, this may provide another benefit to the market. In both cases, these moves move prices closer to the mean. This ensures that large traders do not push prices further away from the average. Keep in mind that whale trades are quite large and they can have a significant impact on the market.

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VWAP limitations

VWAP is mainly used as a single-day indicator. Trying to create a multi-day VWAP may mean that the average will be skewed. Therefore, VWAP is best suited for intraday analysis, i.e. analysis that considers a single trading day or less.

Like the moving average, VWAP is a lagging indicator because it is based on past price data. The more data there are, the greater the lag, which is similar to moving averages. Therefore, a 20-minute VWAP responds faster to current price changes than a 200-minute VWAP.

It is important to remember that VWAP does not have any predictive properties as it is based on past price data.

While VWAP is a powerful indicator used by many traders, it cannot be read in isolation. For example, we have discussed that when the price is below the VWAP line, one may consider an asset to be undervalued. However, in a strong uptrend, the price may not fall below VWAP for quite some time.

As a result, traders waiting for this particular signal may stay on the sidelines and miss out on a potential opportunity. That being said, missing out on a deal doesn't mean the end of the world. If a trader's entry strategy depends on the occurrence of a specific event, and that event does not occur, they should not enter the trade. However, if their strategy is well thought out and they stick to it, it should work out well in the long run. Regardless of the approach, understanding and managing risk is critical.

Summary

The VWAP indicator can tell traders what the average price of an asset is relative to trading volume during a specific period.

Some traders may decide to enter or exit a position based on the intersection of VWAP and price. It can be particularly useful when identifying potential entry and exit points for large trades.

VWAP is a lagging indicator, meaning it has no predictive power for price. Some traders believe that it is best used for intraday analysis. As with any other market analysis tool, you should not interpret VWAP in isolation, it is best achieved when used in conjunction with other techniques.