What is VWAP?

If you’re even somewhat interested in intraday trading, you’ll have heard of VWAP (volume weighted average price). Commonly used by funds for its resistance and support indicators, VWAP is a useful tool for assessing market averages.

Definition of VWAP

VWAP stands for volume weighted average price. It’s the average trading price of a security throughout the day, based on volume and price.

VWAP is generally used by traders as a benchmark for resistance and support or as an indicator for breaking into the market. It’s only used for intraday trading, so you won’t see it on the daily chart or any longer time compressions.

It’s also commonly used by large institutional buyers or funds to minimize market impact and plan long or short positions.

How is it calculated?

The official equation for VWAP is: 

VWAP formula

The math might look complicated, but it's actually pretty simple. Let’s take an example and compare it to a standard moving average (SMA).

Let's say we have 3 trades to measure for the day:

  • Trade 1: 200 shares at $100
  • Trade 2: 50 shares at $110
  • Trade 3: 300 shares at $105

An SMA will calculate the average using solely the price, by multiplying the closing prices and dividing that by 3. This results in an average of $105.

Using the formula for VWAP, things are a little different.

We multiply the volume by the price (200*$100) + (50*$110) + (300*$105) and divide that number by the total volume (200+50+300). This gives us an average of $103.64, which is a big difference if you’re trading in large volume.

What makes VWAP so useful?

VWAP is a lot smoother and easier to predict than a standard moving average. It tends to even out and stay steady as the day goes on, making it a great benchmark for whether a security is above or below the average.

Let's take a look at an example with Apple: 

Graph of Apple stock showing the VWAP and SMA

You can see that the VWAP shows in a smooth line, whereas the SMA is a lot less predictable.

If we look at the blue arrow, we can see the SMA is below the VWAP (this is known as ‘Bearish’) This is a good indicator that a stock is good value and there’s profit to be made by initiating a long trade.

When we look at the yellow arrow, the SMA is now above the VWAP (known as ‘Bullish’) which makes it a good time to make a short trade. 

How can you use VWAP in trading?

There are a couple of key uses for VWAP.

One is to use it as an indicator for resistance and support.

The easiest way to do this is by using the upper and lower bands for VWAP. Let’s take a look at an example of SPDR S&P 500 ETF Trust’s stock

Graph of SPDR S&P 500 ETF Trust’s stock showing the VWAP and SMA

When the SMA goes below the VWAP, the lower band acts as a support and the VWAP acts as a resistance.

When the SMA goes above the VWAP, the upper band acts as a resistance and the VWAP acts as a support.

Another way to use VWAP is to build trade rules for long or short trades.

If the VWAP is positively inclined, the goal should be to make long trades and only buy when the average falls below the VWAP.

If the VWAP is negatively inclined, the goal will be short trades and selling when it crosses above the VWAP. 

What are the limitations of VWAP?

Although VWAP is a useful tool for traders, it should never be the only tool used.

If we look at the previous example with SPDR, even when using the upper and lower bands for support and resistance, VWAP isn’t foolproof. The security breaks through the resistance at 415.75 and keeps rising — so any traders who sold at resistance would have lost out on the peak.

There’s also no negative or positive incline, making it hard to decide on a long or short trading strategy.

VWAP also becomes less reliable as the day goes on.

If we look at this example of Tata Steel: 

Graph of Tata Steel's stock showing the VWAP and SMA

We can see that the VWAP begins similarly to the SMA. However, as the day goes on the VWAP stops following the SMA, and becomes a much less reliable indicator for support.

VWAP is an effective trading strategy and helps to lower risk — just remember to use other indicators alongside it.