There are many types of benchmark indicators that traders use to analyze and make their trading decisions. Read on to understand the Volume Weighted Average Price (VWAP) and how it is different from Simple Moving Average (SMA).
What is VWAP?
In simple terms, the Volume Weighted Average Price gives the average price which investors have paid for a stock for the trading day. It uses intraday data and basically tells about investor positioning. It averages together the closing prices with specific emphasis on volume. Thus, by comparing the price with VWAP, you can know whether your position price is good or bad. If the buying price is lower than the VWAP, it is considered a good trade and visa-a-versa.
On the other hand, the Simple Moving Average is the simplest form of a moving average. It is the mean price over a specific time frame. The term ‘moving’ is used because bars are used as per the changes in average values to plot the chart. Thus, it forms a line which shows the direction of price movement. If the SMA is headed upwards, it means the trend is up and if the SMA is headed downwards, it means the trend is down. A 200-bar SMA is used as a common proxy for long term trends and a 50-bar SMA is similarly used for the short term.
The formula for calculating –
(A = price of asset period & n = the number of total periods)
When is VWAP better than SMA?
Consider the example below –
1st Trade of the day: 100 shares @ 100
2nd Trade of the day: 500 shares @ 101
The Simple Moving Average can be calculated as : 100 + 101 = 201/2 = 100.50
The VWAP Average can be calculated as : ((100*100)+(500*101))/600 = 100.83
Here you can clearly see that calculating the average using VWAP gives you a more accurate price average because it includes trade volume during the calculation. Whereas for the same trades, you can see that the SMA method shows a lesser average price in comparison to the VWAP. Thus, as a trader, you will want to analyze the entry and exit points better. It will help you decide if you’re going to adopt a passive or active approach to trade. With so many transactions taking place with a variety of volumes, it is better to use the VWAP to assist you in figuring out if the price movement is bullish or bearish and thus ultimately helping you to make the right trade at the right time. Intraday traders often prefer VWAP over SMA. It is also popular because algos and institutional traders take their help to scale into positions.
How to Day Trade with VWAP?
The way VWAP is to be used depends upon the investors because they naturally have different motives to trade and do so in different time frames too. This way, the logic with which VWAP is supposed to be used in day trade also changes accordingly.
However, you can use two different setups, known as the trend and the rotational trading setups, when trading intraday. When the grey line moves vertically, it means it is a trend, and when the grey line moves horizontally, it means it is a rotation.
In the graph below, the AUD/JPY 60-minute VWAP is used to demonstrate trend vs. rotation:
It is necessary that you identify the trend and rotation in order to switch between your trade setups.
You will use the trend trade setup when you see a trend and you will use the rotation trade setup for rotation.
The graph below shows the possible trade entries which are as per the two trade setups of trend and rotation.
- trade 1 – this is a short trade – here we follow the trend VWAP setup
- trade 2 – this is also short – the difference here is that it is based on the rotational VWAP setup
- trade 3, 4, 5, 6 – short and long – based on rotational VWAP setup
- trade 7 – here the market goes on a trend, so trade is long – here we follow the trend VWAP setup
This way, we can see that there are two entry points for short and long in the current rotation. This is how VWAP is used by investors to help them decide.
Best VWAP Signals
Bulls and Bears traders can use VWAP during intraday and make profitable trades because they interpret and form their trading strategies based on the following best signals.
- Price above VWAP with significant volumes – the implication is bullish – this indicates a BUY.
- Price above VWAP but with insignificant volumes – the implication is prices being pushed up – this indicates to go SHORT.
- Price below VWAP with significant volumes – the implication is bearish – this indicates a SELL.
- Price below VWAP with low volumes – the implication is prices being dragged down – this indicates to go LONG.
VWAP must always be used for intraday trades. VWAP will always start afresh on any given day. As a trader, if you sell above the daily VWAP, you are subjected to gain a better-than-average sale price. On the other hand, if, as a trader, you buy below the daily VWAP, you are expected to gain a better-than-average purchase price. With the VWAP, you can easily pick what volumes are at play, and this helps you as a trader to either make a buy or make a sell at the right price rather than initiating trades at current prices. Usage of VWAP in a very vigilant and disciplined way by studying the positions will result in a profitable trade for you as an investor. Large institutions, Mutual Funds, and traders using high stakes in terms of funds usually use VWAP to trade.