Traders and investors in the Indian financial markets routinely use various fundamental and technical indicators to formulate strategies and make trading decisions. One such indicator that is used to analyse the prices of securities is VWAP.
If you are unsure what VWAP is and how it is used, this article will give you all the answers you want about this unique technical indicator.
What is VWAP in the stock market?
The full form of VWAP is Volume-Weighted Average Price. It is a technical indicator that lets you know the average trading price of security for a particular period — after it is adjusted for the trading volume. Since the VWAP indicator accounts for the volume of securities traded, it is considered to be a more accurate measure of the average trading price than solely price-based indicators.
Understanding the Volume-Weighted Average Price
Now that you know the meaning of VWAP in the stock market, you may want to gain a deeper understanding of the indicator.
The Volume-Weighted Average Price is a dynamic indicator that changes as the units of the security continue to be bought and sold. By adjusting the average price based on the trading volume, the VWAP indicator smooths out price fluctuations over time and evens out the trading noise created. In other words, it provides traders and investors with a mean volume-adjusted price value.
The VWAP in the stock market is generally represented as a single line on the price chart of a security. Both intraday and short-term traders commonly use it to identify trends. These traders enter trading positions depending on how the security’s price interacts with the Volume-Weighted Average Price.
How is VWAP used?
The Volume-Weighted Average Price is useful for traders in multiple ways. One popular use of VWAP in the decision-making process is to use the metric as an instrument for trend confirmation and creating trading strategies based on it. For example, a security may be believed to be undervalued if its value is below the VWAP. On the other hand, it may be overvalued if its trading price is above the VWAP.
VWAP also influences trading strategies. For instance, a stock’s trading price being above the VWAP encourages investors to take long positions in the market. On the other hand, a stock trading below the VWAP encourages short positions and market exit.
Furthermore, VWAP also influences decisions for institutional investors such as mutual funds. They use VWAP to minimise their impact on the market when buying or selling stocks. Their goal is to buy stocks below the VWAP or sell above it, helping keep prices closer to the average.
Calculation of Volume Weighted Average Price
You can calculate the Volume Weighted Average Price for an asset using the following VWAP formula.
VWAP = (Cumulative Price x Cumulative Trading Volume) ÷ Cumulative Trading Volume |
Here, the cumulative price refers to the total value of all of the prices at which trades were executed during a specific period. The cumulative trading volume refers to the total value of all the trading volumes of trades executed during the said period.
Although it is possible to carry out VWAP calculations for any security using the above formula, you don’t always have to do it manually. Today, most new-age stockbrokers display the VWAP for securities on their trading portals. Alternatively, you can also find the metric on the website of stock exchanges.
How to interpret a VWAP indicator
Monitoring the VWAP indicator can give you valuable insights into the price trend of a security. For instance, if the price of an asset is above its VWAP line, it is considered to be in bullish territory. On the other hand, if the price is below the VWAP line, the asset is said to be in bearish territory.
You can use an appropriate VWAP trading strategy depending on whether the asset is in bullish or bearish territory. Additionally, the VWAP may also indicate potential future price movements.
Importance of VWAP
The VWAP metric can be immensely useful for traders in multiple ways, as explained below:
1. Assessing if the market is trending upwards (bullish) or downwards (bearish)
If the price of a security is above the VWAP, it indicates a bullish market trend. In a similar manner, if a security is priced below the VWAP, it signals a bearish market trend. In a bullish market, the increased buying pressure causes the trend line to move up, and a bearish market with selling pressure pulls the trend line down. These interactions and signals enhance the importance of VWAP for investors to make informed choices based on market sentiments.
2. Making decisions to enter or exit the market
Investors rely on VWAP as an important aspect of technical analysis to decide market entry and exits. VWAP also promotes patience and helps avoid impulsive short-term trades. Instead, as investors look to purchase stocks that trade under the VWAP line, they remain patient and do not pay a price higher than the stock’s average. The VWAP line is a robust indicator that helps traders enter the market at a favourably low price and reap higher profits.
3. An improvement over moving averages
Moving averages are a popular metric in technical analysis for investors in the financial market as they help recognise trends and opportunities to buy and sell positions. However, the VWAP is a more accurate representation of the true average of a stock compared to the moving average. This accuracy is achieved as VWAP accounts for the trade volume of shares at different price points considered in the analysis, assigning weightage to each price point according to the trade volume. This helps the metric adjust its results for sudden extreme fluctuations in prices or trading volume, increasing investor confidence in the tool.
How to trade with VWAP indicator?
Here’s a quick overview of how to use a VWAP indicator. The most common trading technique used involves taking positions based on VWAP line crossovers.
For example, you already know that if the price is below VWAP, the asset is considered bearish; if it is above, it is considered bullish. If the asset cuts across its VWAP line from below and moves past it, this may be viewed as a bullish reversal. You could consider entering into a long position in the asset to benefit from a potential price rise.
On the other hand, if the price of the asset cuts its VWAP line from above, it may indicate a potential bearish reversal. In this case, you may short the asset for some possible gains.
The VWAP indicator is also useful for institutional investors like mutual funds, which often purchase or sell securities in large quantities. Normally, such large orders can impact the market significantly. However, with the help of the VWAP indicator, these investors can purchase or sell securities without creating much of a market impact.
For instance, if an institutional investor wishes to buy 1 lakh shares of a company, they would break up the large order into multiple smaller orders with prices at or near the VWAP. This increases the chances of their orders being executed and leaves a very minimal impact on the market.
Difference between VWAP and simple moving average
While a simple moving average and VWAP are both important tools in technical analysis as they measure the average price of a stock over time, they differ in one key aspect. The simple moving average measures the average stock price by only considering the prices in a given timeframe. Improving upon this, the VWAP accounts for the price of the security as well as the volume of trade at different price levels. It assigns a higher value to price points with higher trade volume and vice versa. Owing to this, the VWAP is an improvement on the simple moving average and is highly relied upon by investors to calculate more accurate averages for stocks.
Limitations of VWAP
By design, the VWAP is supposed to be used on a daily basis. It undergoes a reset as a new trading day starts. If you try to calculate VWAP over a few days, the results may be distorted and inaccurate.
Like other indicators in technical analysis, it is important to view VWAP results in conjunction with other metrics. For example, in a bullish trend, the increasing prices may not drop below the VWAP level and waiting for the drop to enter the market may lead to a lost opportunity. At its core, the VWAP can be called a historical indicator. Thus, it should not be used as a predictive indicator.
VWAP accumulates data throughout a trading day. It reacts quickly to price changes early in the day because it is based on fewer data points. However, as the day progresses and more data accumulates, it becomes less responsive to new price movements.
Conclusion
This sums up what the VWAP means and how you can use it to trade in the financial markets. Before using the indicator, you should know that it is not advisable to rely only on the Volume Weighted Average Price for trading decisions. Instead, you can use it along with other technical indicators or candlestick patterns. This way, you can not only avoid false trading signals but also increase the chances of success of your trading decisions.
