What Is Volume-Weighted Average Price (VWAP)?
Volume-weighted average price is a financial term for the ratio of the value traded to total volume traded over a particular time horizon. The measure helps investors and analysts compare the current price of stock to a benchmark, making it easier for investors to make decisions on when to enter and exit the market. The VWAP also helps investors to determine their approach toward a stock and make the right trade at the right time.
- Volume-weighted average price (VWAP) is a financial term for the ratio of the value traded to total volume traded over a period.
- The measure compares the current price of stock to a benchmark.
- The VWAP uses intraday data.
- VWAP can indicate if a market is bullish or bearish and whether it is a good time to sell or buy.
Understanding Volume-Weighted Average Price (VWAP)
VWAP is a measure that helps investors decide whether to adopt an active or passive approach or whether to enter or exit the market. Also, the VWAP can assist investors in making the right trade at the right time.
Calculating Volume-weighted Average Price (VWAP)
The VWAP is calculated for each day beginning from the time that markets open to the time they close. Thus, the calculation uses intraday data. The formula for calculating VWAP is as follows:
Volume-weighted average price = typical price x volume/cumulative volume
The first step in the calculation is to find the typical price for the stock—this is the average of the high price, the low price, and the closing price of the stock for that day. Using the formula [(H+L+C)/3], if H = 40, L = 30 and C = 36, the stock’s average price would be:
Average Price = (40+30+36) / 3 = 35.33
The next step is to multiply the typical price by the volume. If V = 20, then:
35.33 * 20 = 706.60
A running total of the volume is aggregated through the day to give the cumulative volume. The cumulative volume, in our example, is 78.
Therefore, using the VWAP formula above:
VWAP = 706.60 / 78 = 9.06
The VWAP can be calculated for every period to show the VWAP for every data point in the stock chart. This is done automatically by trading software. Thus, the trader only needs to specify the desired number of periods to be considered in the VWAP calculation.
The Significance of VWAP
The VWAP represents the true average price of the stock and does not affect its closing price. The VWAP calculation is based on historical data so it is better suited for intraday trading. VWAP is a popular tool among investors because it can indicate if a market is bullish or bearish and whether it is a good time to sell or buy. The VWAP is also considered a superior tool to moving averages.
Applying the VWAP
Using the volume-weighted average price (VWAP) when trading in short-term timeframes is highly effective and simple. One common strategy for a bullish trader is to wait for a clean VWAP cross above, then enter long. When there is a VWAP cross above, the stock shows that buyers may be stepping in, signaling there may be upward momentum. When a stock's price breaks above the VWAP, the previous time frame's VWAP can be thought of as a support level.
A trader can also use the VWAP in conjunction with Bollinger bands. These are a set of trendlines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of a security's price that can be adjusted to user preferences. An investor can short a stock with a clean VWAP cross below and cover a short position if the stock breaks below the lower band and vice versa when buying.
For example, if a stock is trading at $39.90 and the VWAP is $39.95, and a trader sees a VWAP cross above $39.95 and the stock price goes higher to $40.05, they can look to get long on this VWAP break to the upside. The stock may be showing signs of strength and momentum to the upside. Now, if traders are using this VWAP strategy along with Bollinger bands, they can define a target if the stock gets above the upper band, and can also have a stop-loss order placed if the stock breaks below the VWAP, depending on their risk tolerance.