What Is the Volume-Weighted Average Price (VWAP)?

What Is the Volume-Weighted Average Price (VWAP)?

Let me explain VWAP directly: it's a technical analysis indicator you see on intraday charts, and it resets at the beginning of every new trading session. Essentially, VWAP gives you the average price a security has traded at during the day, factoring in both the price and the volume of trades.

You should know that VWAP matters because it offers insight into the price trend and the overall value of a security. As a trader, you can use it to gauge what's happening in the market right now.

Key Takeaways on VWAP

On your charts, VWAP shows up as a single line, similar to a moving average but smoother in its appearance. It captures the price action for an entire trading session in one view. Both retail and professional traders turn to VWAP to figure out intraday price trends, and it's especially handy as a benchmark for short-term trading.

Understanding the Volume-Weighted Average Price (VWAP)

To get VWAP, you total the dollars traded for each transaction— that's price times volume—and then divide by the total shares traded. The formula looks like this: VWAP equals the sum of (tick price times tick volume) divided by total trading volume.

Not every trader has access to precise data for this, so many charting tools use an approximation. They calculate it as cumulative typical price times volume, divided by cumulative volume, where typical price is the high plus low plus close divided by three, and cumulative means totals since the session opened.

How to Calculate VWAP

If your charting software has a VWAP indicator, it handles the calculation automatically when you add it to a streaming chart. But if you want to do it manually, here's how: assume you're using a five-minute chart, though the timeframe doesn't change the method.

Start by finding the average price for the first five-minute period—add the high, low, and close, divide by three, then multiply by that period's volume to get PV. Divide PV by the volume to get VWAP for that point. To keep it going through the day, add each new period's PV to the previous total and divide by the cumulative volume up to then. In a spreadsheet, set up columns for cumulative PV and volume to make this straightforward.

How Is VWAP Used?

Traders apply VWAP in various ways, like using it to confirm trends or set trading rules. For example, if a stock's price is below VWAP, you might see it as undervalued and go long when it crosses above; if above, it could be overvalued, prompting a short or sell when it dips below.

Institutional players, such as mutual funds, use VWAP to enter or exit positions with minimal market disruption. They aim to buy below VWAP or sell above it, which helps pull the price toward the average rather than pushing it away. Remember, VWAP's volume weighting reveals trading activity levels, showing if others are entering or exiting positions during short periods.

VWAP vs. Simple Moving Average

At first glance, VWAP and a simple moving average (SMA) might look alike on a chart, but they're calculated differently and tell different stories. VWAP multiplies typical price by volume and divides by total volume, incorporating trading activity directly.

In contrast, SMA just adds up closing prices over a period and divides by the number of periods, ignoring volume entirely. This makes VWAP more reflective of actual market dynamics.

Limitations of VWAP

VWAP is strictly a single-day tool that resets each session, so trying to average it over multiple days would distort the results and give you an unreliable indicator. While institutions might buy below or sell above VWAP, it's not the sole factor in decisions—other elements come into play.

In strong uptrends, prices can keep rising without ever falling below VWAP, meaning you could miss opportunities by waiting for that signal. Also, since VWAP relies on historical data, it lacks predictive power and lags more as the day progresses, often resembling a long-period moving average by session end.

What Does the VWAP Tell You?

VWAP informs you about a stock's liquidity and the price where buyers and sellers are finding agreement. You can monitor price movements throughout the day with it, getting a clear picture of intraday dynamics.

Why Is the Volume-Weighted Average Price Important?

VWAP provides a smoothed indication of a security's price, adjusted for volume over time. Institutional traders use it to avoid overly influencing the market— for instance, a hedge fund won't buy above VWAP to prevent inflating the price, or sell too far below to avoid dragging it down.

Is VWAP a Leading Indicator?

No, VWAP isn't a leading indicator; it's lagging because it depends entirely on historical data without incorporating real-time elements. This limits its use for traders needing immediate information.

The Bottom Line

In summary, VWAP is a technical indicator you use during single trading sessions to find the average price of a security based on price and volume. It gives you insights into liquidity and price movement, helping with intraday decisions.