Volume weighted average price (VWAP) is a trading benchmark that is often used by investors, and it does what it says on the tin: reflects the ratio of an asset's price to its total trade volume.
VWAP is calculated by adding up the money traded for every transaction and then dividing by the total shares traded for the day. Often used in pension plans, when VMAP is used in stock investments the calculation starts when trading opens and ends when trading closes.
Traders find it useful because it simplifies decision-making strategies by identifying the true average price of a stock by factoring the volume of transactions at a specific price point and is not simply based on the closing price.
It helps large-scale traders stagger their trades to ensure that all their trades match the volume of trades available - they only offer to sell enough shares as there are buyers, for example. This ensures high liquidity that can help lower transaction costs. It also stops the price being changed rapidly because of an oversupply of either buyers or sellers.
VWAP will not work out everything for traders and sound trading decisions need to be made based on the market trends, but what it does is answer two key questions: did the stock close at a high with low volume or did the stock move to a new low with light volume?
History of VWAP in trading
The origins of VWAP trading strategies date back to the 1990s when foreign investors were eager to invest in US equities. According to Themis Trading, an independent brokerage specialising in equities, traders embraced them because they are safe. While they will never "hit a home run", they don't “strike out” either - at least in large-cap stocks if their volume participation is kept in check.
In a note to investors, it said that the stock market was hot back then but some of those US brokers took their best execution duties less seriously than they should have.
"Overseas clients going home for the day would give their US stock orders to their US brokers each morning and get their fills back from them the following morning. Comparing the fills to the intraday charts was a sometimes sad and sometimes humorous exercise.
“These London traders dreamed of a day where they could hope for a marginally average, and not-horrifically-bad, trade execution – and the VWAP benchmark was born.”
As more traders execute trades using VWAP concepts, the day's volume curve has increasingly become more predictable, and a self-fulfilling prophecy.
The VWAP ratio is also often used by large institutional buyers and mutual funds to prevent price disruption. By moving into stock over a few days, they limit the impact on market dynamics.
A moving average
VWAP is similar to a moving average in that it helps eliminate much of the noise seen in stock throughout the day, but even more so than a moving average would. When the price is high, it is above VWAP and when the price is low, it is below VWAP. It is thought that when a stock tries to break above or below the VWAP level multiple times throughout the day, traders and analysts can see that it is a good price at which to either buy or sell.
Ross Cameron, a full-time day trader and owner of Warrior Trading, says there are three reasons why VWAP is a favourite tool for day traders. The first is that it is an important indicator of market sentiment, it is excellent for risk/reward and it also provides more value than a standard moving average.
He says: "As an important indicator, when the price is above VWAP, the trend can be said to be bullish and when the price is below VWAP, it is bearish. A bullish market is characterised by the increase in buying price and the trend on the chart is seen as moving upwards.
"Meanwhile in a bearish market, it is characterised by increased selling pressure and the trend is charted as moving downwards. This is how VWAP scores as an important indicator of market sentiment."
And it may be inaccurate or misleading for large orders that require many days to fill. For example, if an order is so big that it becomes 100% of the market volume, the performance to VWAP will become zero as the order becomes the benchmark itself.
VWAP can be only used to manipulate trading by placing trades when market prices are at levels favourable with VWAP. This is when the methodology triggers a trader to buy at a particular time when shares are showing the fair market price accurately. The indicator becomes less sensitive to price action as the market day extends. Later in the day, the "lag" can become significant.
Identify entry and exit points
Unlike moving averages, VWAP assigns more weight to price points with high volume. This allows the trader to understand price points of interest, gauge relative strength, and identify prime entries/exits.
Since stocks trade above, below and at the VWAP, as a trader, you need to enter when stocks are making a pivotal decision. It is not just about placing trades, but placing them so they make the best use of your time and money. For example, if a stock begins to climb above the VWAP, this is a sign that the odds are in your favour for a sustainable move higher.
The key thing is watching for price increase with significant volume that will give confirmation that the stock is likely to run in your desired direction. Cameron adds that doing this will not only counter-trend trading opportunities, but it will reduce market impact.
The VWAP is a good tool for measuring the relative strength of stock. As it is easy to calculate and understand, it is most useful for evaluating small trades.
It does, however, have some documented disadvantages. For a start, it doesn't take into consideration market impact and trades throughout the day.
As it does not account for order timing, it can't show the opportunity cost if the execution is started too early or too late because it does not tell you precisely when the price and supply of trades are at its peak. You risk missing the best time to trade.
VWAP also does not provide entry or exit signals, stop loss or target levels. In addition, it doesn't work well in a high volatility environment. It works bests where the bid/ask spread is small.
VWAP lags price simply because it is an average depending on past data. The more data there is, the greater the lag. For example, if a trader is using a one-minute chart, after five hours of trading, VWAP has been computed for 300 intervals. The lag related to this would be similar to a 300-period moving average.
VWAP might be of more value to day traders at the start of the day because it is more responsive to price moves. By the end of the day, it is harder to determine overall fluctuations in movement.
However, to major institutions these later values are more important since the end of the day VWAP value gives a benchmark against which the institution can compare their transactions. Therefore, retails traders enjoy the benefits early in the trading session and institutional traders benefit most at the end of the day.
VWAP as a trading benchmark
As it is easy to understand and to execute, VWAP is a common measuring stick for best execution in the investment community. VWAP is still seen by many traders as a great technical indicator simply because it represents both price and volume.
Although there is a lag, the VWAP can still be compared to the current price to see the trend of intraday price movement. Before investors use VWAP as a benchmark, however, it is important to understand when using VWAP is appropriate