are an important part of the analysis of financial markets. Moving averages are the simplest and most popular indicator among the basic instruments of every trading platform.
Dozens of the same basic and combined indicators are built on their basis. And yet, like any other indicators, moving indicators are not without drawbacks: they calculate the average price based on the prices of individual timeframes but do not take into account the trading volumes within them. Attempts to improve the underlying instrument have led to exponential moving averages and other varieties of this instrument.
One of such derived indicators is VWAP (Volume Weighted Average Price), which takes into account trading volumes in price averaging. The indicator combines the power of volume with price action to create a practical and easy-to-use indicator. Traders can use VWAP as a trend confirmation tool or as a tool to identify entry/exit points.
Today we will take a closer look at what VWAP is, how it works, and how traders can incorporate it into their trading strategy.
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What is the VWAP?
VWAP (Volume-Weighted Average Price) is the average price of an asset over a given period, weighted by volume. It is used mainly as an auxiliary tool when working with other technical analysis tools. The main purpose of VWAP is to display the activity of players at a certain point in time. Besides, this indicator can sometimes predict an imminent trend reversal. If the price line is above the indicator curve, it means that at the moment there is an uptrend, if below - a downtrend. As soon as VWAP starts to decline steadily, we can talk about a drop in general interest in the asset. It is highly likely that the market will soon be in a flat. It is very difficult to predict how this period of small volumes will end. At the same time, the asset itself becomes as sensitive as possible to any price fluctuations, including even minor ones. It can be argued with a high degree of probability that a fairly powerful trend will be formed. But to understand what it will be - ascending or descending trend, it is necessary to attract additional analytical indicators.
The ability to determine the current market volumes for the study asset can not help to identify the direction of the trend. Therefore, it makes no sense to use the VWAP indicator to solve such problems.
How to calculate VWAP?
On most trading terminals, one can just select the indicator, and the calculations will be done automatically. But if you go into details, then the calculation formula will be determined by multiplying volumes by price and then dividing by the total amount of volume.
VWAP = ∑ ( Price * Volume ) / ∑ Volume
Let's take a closer look at each meaning and effect in the formula:
Price. The average price value for calculating VWAP can be based on a different set of data. Some versions of the indicator provide for changing the price type. For example, using only the average market closing prices, lows, and highs; or the average of the opening and closing prices of the market, the highest and lowest prices for the day.
When setting average prices, one can see the following values in the indicator:
Median price - calculated as follows: (High + Low) / 2
Weighted price - calculated as follows: (High + Low + Open + Close) / 4
Further, according to the formula, the resulting value of the average price is multiplied by the volume.
The numerator is calculated: the average price is multiplied by the volume for the entire period. The whole period means the number of candles specified in the indicator settings (VWAP period).
The denominator is calculated: the cumulative volume for the entire period.
Calculates the ratio of the numerator to the denominator
The weighted average price is calculated for the specified period. The calculation can be done for different timeframes. The VWAP indicator calculates data from the beginning of the period specified in the settings (for example, hour, day, week) to the endpoint in cumulative mode. In this case, the data are not averaged. It is also important to set the correct time in the indicator settings. Also, the trader needs to indicate the desired number of periods that should be taken into account when calculating VWAP. The VWAP results are presented on the asset chart as a line (see above).
VWAP indicator signals
If the price is above the indicator for a long time, then the trend is upward, if the price is below VWAP - this is a sign of a downtrend. We are talking about a long period, which is usually analyzed before opening a deal for a general assessment of the state of the market.
If VWAP is located above the price, then it means that a long position (buy) will be opened at a lower price than the average market quotes. One of the high-risk strategies is based on the fact that, for example, a buy trade is opened when the price is below VWAP, but reverses. In accordance with conservative strategies, a long position is opened when the price crosses the indicator from bottom to top, short - from top to bottom.
If the indicator crosses the price chart several times, then the market is flat.
If VWAP starts to decline steadily, it means that trading volumes are decreasing and interest in the asset is falling. Such a signal can be a precursor to a flat.
How to use VWAP?
The meaning of the indicator is that the location of the price chart relative to the VWAP indicator line indicates the strength of sellers or buyers. The higher the price is from the VWAP curve, the stronger the influence of bulls in the market. If the price is significantly below the VWAP, then bears dominate. The VWAP indicator line often acts as a support or resistance level, and a breakout of this level means a change in the local trend and serves as a buy or sell signal.
It is very easy to make a mistake when detecting a trend change on small time frames, so more experienced traders use VWAP standard deviations for the Trend strategy. It is believed that a breakout of the second square deviation is a fairly reliable signal to buy or sell. Extreme square deviations show that the price has reached the channel border and may soon change the direction of the trend.
In the phase of price consolidation, the Reverse Strategy algorithm is often used, which is based on the fact that at the maximum deviation, the price returns to the VWAP indicator curve.
A fairly successful trading strategy can be built on the basis of the VWAP indicator. Of course, this indicator is not a universal trading tool, but on its basis, it is possible to implement a Reverse or Trend strategy to determine entry points and StopLoss/TakeProfit levels.
