Volume-Weighted Average Price Explained
An essential aspect of analyzing the financial markets are technical indicators. Some of them are aimed at illustrating momenta like the MACD, the StockRSI, or the Relative Strength Index(RSI). Others are most likely used to locate the possible point of interest on a chart like the Bollinger Bands, Parabolic SAR, or Fibonacci Retracement tool. However, what is the most fundamental indicator in existence? In context, it is volume. A volume is a general tool used for confirming a trend, identifying possible points of reversal as well as numerous other strategies.
The VWAP combines the power of volume, along with price action, in order to develop an easy-to-use and practical indicator. Traders can also make use of VWAP as a tool for confirming trends or noting points of exit or entrance in a market. VWAP provides numerous benefits; however, before diving into that aspect, it is necessary first of all to understand what VWAP is, including what it entails and how it can be included in a trading strategy.
What Is Volume-Weighted Average Price?
VWAP, as its name best suggests, refers to an asset's average price for a given period determined by the volume. It can also be defined as a trading benchmark used to obtain the price that a security has traded at. VWAP is essential as it provides traders with the knowledge of both the value and trend of a security.
Why VWAP is effective, is because of how it integrates volume into the price calculation. Generally, some traders are of the opinion that volume is the most important metric in existence even outside of the price action itself. In context, why VWAP remains a handy tool for both traders and analysts is because of how it combines the two essential metrics into one indicator. The VWAP is capable of giving an indication of the dominant market trend and also essential areas of liquidity.
How To Calculate Volume-Weighted Average Price?
On various trading interfaces, one can easily select the indicator, and the calculations will immediately be carried out for you; irrespective of this, it can be beneficial to know the formula behind it still so as to enable you to use it more efficiently. VWAP is easily gotten through the addition of the money traded on every transaction, before dividing by the total shares traded.
VWAP = ∑ Price multiplied by Volume and divided by ∑ Volume
As earlier stated, including the VWAP indicator in a chart will aid in completing all calculations for you, however, if you want to calculate the VWAP yourself, you can easily do that by following some necessary steps:
For example, let’s use a five-minute chart; in this case, the calculation remains the same.
1.Find the stock’s average price. This can be done by adding the high, low, and close before dividing by 3. It should then be multiplied by the volume.
2.PV should be divided by the volume, which will, in turn, give the VWAP value.
3.In order to maintain the value of the VWAP throughout the day, continued adding the PV value period to the prior values. Proceed to divide this total by the total volume up to that point. It is suitable to make columns for cumulative volume and PV. Then divide the cumulative values by each other in other to get the VWAP.
What The Volume-Weighted Average Price Tells Traders
For those who have an interest in a longer-term investment approach, the VWAP could likely serve as a benchmark for the current market outlook. A straightforward strategy might be purchasing assets that are below their VWAP line, which serves as an indication that they are potentially undervalued. Having established that, some traders may also make use of the price crossing the VWAP line as a sign to enter a trade. If the price breaks through and goes beyond the VWAP, then they will most likely get into a long position. Also in the same way, if the price goes below the VWAP then they may enter a short position.
Generally, the VWAP can also serve the purpose of moving averages. If the price is beyond the VWAP line, then the market would most likely be seen as bullish. In the same way, if it is below the VWAP line, then the market may be regarded as bearish, although this greatly depends on the context of the technical pattern and should be handled with caution. The VWAP can also be useful in measuring the efficiency of trade execution as well as identifying areas of liquidity. This is beneficial for institutional traders who are seeking to fill large orders. In this case, the indicator aids in helping them in determining appropriate entrance and exit areas for huge trades, which could reduce their impact on the market.
Limitations Of The Volume-Weighed Average Price
While there is no doubt that the VWAP comes in handy as a single-day indicator, however attempting to create a VWAP over multiple days basically means that the average will most likely be distorted. Due to this factor, the VWAP functions more efficiently for intraday analysis, and this refers to an analysis that takes into account one trading day or less
The VWAP remains a lagging indicator similar to moving averages, as it is based on previous price data. And like a moving average, more data is equal to a greater lag, and as a result, a 20-minute VWAP will most likely react more quickly to the present price movement as opposed to a 200-minute VWAP. It is necessary to remember the VWAP doesn’t possess any predictive qualities as it is based on previous price data.
Though the VWAP remains a potent indicator which numerous traders, it is important for it not to be interpreted in isolation. As earlier stated, when the price is below the VWAP line, it may be seen as undervalued; however, in a powerful uptrend, there is a chance that for a considerable amount of time, the price may not go below the VWAP line.
As earlier explained, the VWAP is a lagging indicator which means that it has no predictive qualities for price. Various traders are often of the opinion that it is perfect for intraday analysis. However, similar to the other market analysis tool, the VWAP functions more perfectly when combined with other strategies which are why it should never be interpreted in isolation.
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