VWAP, or volume-weighted average price, is calculated over a given period, usually a single trading day. It reflects the average price at which an asset has been traded, adjusted based on the volume of each transaction.
As a technical analysis tool, the VWAP indicator is widely used by traders to assess an asset's price dynamics throughout a trading session. Unlike other trend indicators, which only consider price movement, VWAP also includes trading volume, making it invaluable for identifying areas of support, resistance, and underlying market trends.
In short, VWAP provides a more accurate overview of key price levels by factoring in not only the asset's price but also the volume tied to each trade. Institutional traders and fund managers frequently rely on VWAP to evaluate whether their trades are favorable compared to the weighted average for the day.
To calculate VWAP, multiply the asset price by its trading volume over a given period, then divide the result by the total volume traded over the same period. This process is repeated for each interval, and the average is plotted on a chart over the trading session.
Using VWAP in Trading
Traders utilize VWAP in various ways, especially to measure performance and guide their entry and exit strategies. For example:
1. Intraday trend detection: If an asset’s price is above VWAP, this may indicate an upward trend, while a price below VWAP could suggest a downward trend. Traders often use this information to determine when to buy or sell.
2. Evaluating trade performance: Institutional traders often compare the average price of their trades with the VWAP. Buying below VWAP indicates a favorable price, as it’s below the weighted average for the day.
3. Support and resistance levels: VWAP can act as a support or resistance area. When prices approach the VWAP, consolidation or rebound often occurs, as traders consider this level as a key reference point.
4. Mean reversion strategy: Some traders use VWAP in mean reversion strategies, speculating that prices will eventually return to VWAP after significant deviation.
Limitations of VWAP
While VWAP is a powerful tool, it has limitations. Firstly, it’s a lagging indicator, reflecting past data and not responding immediately to sudden market changes. As such, it's more effective for intraday trading than long-term predictions.
What's more, VWAP resets daily, limiting its usefulness for multi-day or weekly analysis.
Finally, VWAP doesn’t account for volatility forecasts or fundamental data, so it should be used alongside other indicators for a more complete analysis.
