Understanding The Volume Weighted Average Price (VWAP)

VWAP explained

The Volume Weighted Average Price, or VWAP, gives us the average price that an asset has traded over a given period. VWAP is calculated by adding up the dollars traded for every transaction (price multiplied by the number of units traded) and then dividing by the total units traded.

VWAP calculation

In the traditional markets, both traders and portfolio managers will use VWAP to essentially determine where fair value has been established throughout a trading period. Think of this as an indication of where on average the most business had been transacted, and therefore where the most risk was put on.

If building a larger longer-term position, a portfolio manager might rely on the VWAP to identify where they can get involved in an area of high liquidity. This allows them to have a minimal market impact. They might also use daily VWAP as a reference point for times when the price might fall well below “value”, and offer what might be deemed as a discount.

Shorter-term traders, on the other hand, can use VWAP in many different ways. Some traders will use VWAP along with standard deviation bands similar to how Bollinger bands might be used. In a mean-reverting environment, when the price gets extended from “fair value”, we often see a reversion to the mean. A trader might short rejections at the upper outer SD bands, or long bounces off the lower outer SD bands.

Depending on the individual’s system, some traders may take longs when price reclaims topside of the VWAP and target one of the upper outer SD bands; or the inverse by shorting if price falls below the VWAP, with targets of the outer lower SD bands.

One of the best ways we can use VWAP though is not only to identify where most of the risk had been put on but from this, who might currently be in control as a result.

If we are using something like the 20 period daily moving average, the standard default setting is entirely based on candle closes and tells us nothing of the actual trading activity and participation that took place.

By using a VWAP we get an actual picture of where most of the volume was transacted over the course of a trend. If over the course of a week we know where the VWAP is, we can begin to make assumptions about who is in control depending on where we sit in relation to this VWAP.

If most of the trading was transacted at 9000 for the week, and we are currently trading at 9200, then we might correctly assume that longs are in a better position than shorts. As a result of this control, it might be a better idea to therefore look for longs in order to go with the current dominant flows. On the flip side, if the price begins to trade back below the 9000 VWAP, then most of those longs would be in pain and set up for a long squeeze as they looked to close out.

An example of a shift in control can be seen in the image below, where VWAP will act as dynamic support and resistance. Price had spent 1-week trading below 7-Day VWAP before claiming the upside. Upon taking over this level shorts that were positioned poorly were off-side. This often presents short term trading opportunities that can position themselves in advance of a squeeze. In this case, longs would have been welcomed upon signs of strength above VWAP once we crossed and held.

This tool does not need to be overthought. For many traders is it part of how they define their current default bias.

As in

  • If the price is trading above VWAP I will prioritize looking for longs
  • If the price is trading below VWAP I will prioritize looking for shorts

Try experimenting with this on your test account at Phemex to see how you can begin to incorporate this into your trading. This can be an invaluable tool to use, for all types of market players.

By Ryan Scott (@CanteringClark)

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