What is the 'Volume Weighted Average Price - VWAP'
The volume weighted average price (VWAP) is a trading benchmark used especially in pension plans. VWAP is calculated by adding up the dollars traded for every transaction (price multiplied by number of shares traded) and then dividing by the total shares traded for the day.
The theory is that if the price of a buy trade is lower than the VWAP, it is a good trade. The opposite is true if the price is higher than the VWAP.
BREAKING DOWN 'Volume Weighted Average Price - VWAP'
Volume-weighted average price (VWAP) is a ratio generally used by institutional investors and mutual funds to make buys and sells so as not to disturb the market prices with large orders. It is the average share price of a stock weighted against its trading volume within a particular time frame, generally one day.
Large institutional investors or investment houses that use VWAP base their calculations off every tick of data during a trading day. In essence every closed transaction is recorded. However, most charting websites and individual investors may prefer to use one-minute or five-minute trading prices in order to cut down on the sheer volume of data required to keep track of VWAP in a day. For a five-minute VWAP calculation you would take the low, plus the high, plus the closing price within the five-minute period and divide the total by three. This gives you a time-weighted average price (TWAP) that is fairly accurate, and you can multiply this number by the volume traded in the same period to achieve a weighted price.
Why Use VWAP
Large institutional buyers and mutual funds use the VWAP ratio to be able to move into stocks in a way that will not disturb the natural market dynamics of a stock price. If these buyers were to move into a stock position all at once, it would unnaturally elevate the stock price. Yet buying purchasing shares under the intraday VWAP moving average, these buyers can move into a stock over the course of a day or two without too much price disruption.
However, there are other uses for the VWAP, and one such strategy is to purchase a stock for individual investors just as the VWAP pierces the intraday VWAP moving average, as this can indicate a momentum shift in the share price. It is also used in algorithmic trading and allows brokers to guarantee the execution of a trade near a certain price volume for clients.
VWAP is cumulative indicator and as such the number of data points increases throughout the day. This increasing dataset, over longer periods of time, such as four, six or eight hours in a day can cause lag between the VWAP moving average and the actual VWAP. As such, most investors never use a VWAP longer than one day.