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VWAP Trading Strategy - Volume Weighted Average Price

Views 17KMar 22, 2024

Take your VWAP trading strategy to the next level

When it comes to deciding when to get in or out of a trade, the volume-weighted average price (VWAP) is a helpful indicator because it doesn't just consider the average price, but adjusts for the volume of trades. By calculating the cumulative typical price x volume divided by cumulative volume, you have a much clearer picture of where the market momentum is heading and how you want to proceed.

Using a VWAP trading strategy in conjunction with other indicators is a valuable skill for any trader's toolbox — whether new or advanced. To improve your VWAP trading strategy, there's a few key points you'll want to understand:

• Why the VWAP is important

• The limitations of the VWAP

• VWAP strategies you can apply

• VWAP patterns to include in your strategies

Because individual and institutional traders alike use the VWAP to decide when to execute trades, it is seen as highly influential on price action. This valuable tool has a lot to cover, so let's dive in.

Why is the VWAP important?

The VWAP is based on historical data, so it is a lagging indicator. However, it can provide useful insight as well as act as support and resistance levels for intraday trading. It is displayed similar to a moving average, but can move much slower than an 8- or 20-day moving average.

Images provided are not current and any securities are shown for illustrative purposes only.

When using the VWAP, traders are able to see a smoothed line of a stock's price over time, typically a one-day time frame, with the adjustment of volume. Because it doesn't impact the stock's closing price and is adjusted for volume, many analysts view the VWAP as a truer representation of an average price. In addition, institutions and pension plans often look to the VWAP, so many traders view it as highly influential on the market. These large entities use the VWAP to find entry and exit points that may help them avoid disrupting the market and moving the price of the security they wish to buy or sell — disruptions which, as a result, would create unfavorable entry prices for their trades.

Limitations of the VWAP

The VWAP is typically used as a one-day indicator and resets at the start of each new trading day. Trying to create a longer average can distort the chart and result in false signals. The calculations for finding the VWAP are not predictive, instead being tied to the opening price range of that trading period. With this in consideration, it is important to know that the lag increases as the day progresses.

In addition, because it is a lagging indicator, it shouldn't be the only indicator you use to determine your strategy. On the large scale, institutions may wish to buy when the price of a stock is lower than the VWAP or sell when it's above. But, for example, the price may continue to increase in strong uptrends for multiple days. If traders rely solely on the VWAP and wait to enter until after the price falls beneath it, they could miss key opportunities if the prices are rising quickly.

VWAP strategies you can apply

As previously mentioned, institutions and pension plans will often use the VWAP as a key indicator in order to take large positions. They often wish to buy below the VWAP, but not significantly enough to drive the price lower. The opposite is also true, as they often exit when the price is moderately above the VWAP to avoid possible missed opportunities or losses if they cause the price to spike.

With professional traders and institutions using the VWAP as a benchmark, it may be important to factor this dynamic into your strategy. Applying it for short-term, intraday trading can be as simple as buying when the closing price first goes above the VWAP and selling higher than that.

A more complex approach would be to use the VWAP as a filter, going long when the price is below and short if the price rises above, otherwise known as short selling. Short selling is the process of selling borrowed stock at the current price, and then closing the trade by purchasing the stock at a future time. What this essentially means is that, if the price drops between the time you enter the trade and when you deliver the stock, you turn a profit minus any fees or expenses. This strategy may be a good option during trading periods with sideways price action as it assumes buyers aiming to beat the benchmark can support the price when it's below the VWAP, rather than when it's above.

On the other hand, some traders may take the opposite approach, entering the market only when the price is above the VWAP and short-selling only when the price drops below. This tactic may be good on days with an obvious trend as it assumes benchmark watchers would be unable to get the price they desire and are forced to push the trend further for the day, whether upward or downward.

It is important to note that neither of these tactics seems to hold a statistical edge when executed over a large number of trades. That is why many traders believe it is essential to combine their VWAP strategy with other indicators for a more effective filter.

VWAP patterns to include in your strategies

There are four useful strategies you can employ with the VWAP to help find the entry points and risk/reward that fit your goals.

VWAP pullback

When looking at a chart with a 20-day moving average and a VWAP, it's very common for the latter to move more slowly. Some traders will use a strategy wherein they short when prices close under where the VWAP crosses the 20-day moving average and buy when it closes above.

Images provided are not current and any securities are shown for illustrative purposes only.

Another tactic is to let the market first move for a couple of candles and then wait for a pullback toward the VWAP. Once this pullback has occurred, you can get long or short with the trend, depending on which way the market is moving.

This strategy can offer a clear entry point because you know that if the price closes on the other side of the VWAP from where you got it, it may be a good time to get out. Often, prices that are sold off will rally into the VWAP and then sell off for another downward trend. If you take the pullback approach, you would time your entry so it is as close as you can get to the VWAP with a stop close above. Traders often look for the VWAP to break lows for their profit targets so they can add more size in order to take profits once they work in their favor.

A Fade to the VWAP

Images provided are not current and any securities are shown for illustrative purposes only.

If you're interested in contrarian investing, using a fade to VWAP strategy can make it easier to understand your risk and reward. If a stock had a good run at first during a trading day, but began to consolidate to the point where it failed to make new highs, it can be an indicator that buyers are no longer interested and the price may drop. This strategy also works well to determine overextended prices when combined with bollinger bands.

In this approach, you would short towards the high and stop just over it, where your price target is the VWAP. However, you can also take off some risk around halfway down from the highs and then take the rest off once it has reached your target. Some key features you want to see happen include a strong upwards trend with multiple legs, followed by hesitation at the top and a failed new high. When this price action is seen, some traders will take a short position to try and earn a profit.

VWAP Hold & Go Pattern

This pattern can be easy to identify and may offer your preferred risk and reward balances. With this approach, you should look for a stock that has a catalyst with an upward trend in the pre-market hours and then a strong opening once the market hours start. Then, a tight wedge pattern should emerge while remaining above the main moving averages.

Images provided are not current and any securities are shown for illustrative purposes only.

With this setup, there are a couple of ways to strike. You can first take small positions as the price bounds along the low end of the wedge and add when it has a breakout above it. Or, you can wait for the actual breakout before you move, at which time you'll take a full position. In this situation, you would use the VWAP as your stop.

When looking for a confirmation signal, you would consider the volume. If the volume spikes and significantly increases after the breakout, it can push prices higher very quickly after it holds the VWAP.

VWAP Support & Resistance

On days with fairly sideways price action, the VWAP may become a very useful filter when combined with a price envelope. In this situation, your strategy would be focused on making trades expecting the price to revert to the average price for the day. With this tactic, you would enter long positions when the price is between the VWAP and the lower price band, known as the support region. On the other hand, you may want to initiate short-selling positions when the price is ranging between the VWAP and the upper band, known as the resistance region.

Images provided are not current and any securities are shown for illustrative purposes only.

One trading strategy for sideways markets may be to initiate a long position when the price closes within a support region while you have a stop-loss order set up beyond the farthest line of the region, and a profit target at the VWAP. A similar setup can also be used in the reverse for short-selling around the resistance region.

Key Takeaways

For advanced traders, incorporating the VWAP can provide significant depth for intraday trading strategies. However, it is important to remember that the VWAP should not be the only signal you look at. Because it is a lagging indicator, it is best to use this technique in conjunction with other forms of technical analysis for a stronger strategy.

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