Today we are going to introduce you an indicator which takes into consideration price and volume. Behold the mighty Volume Weighted Average Price (VWAP) indicator! VWAP indicator explained.
What is the Volume Weighted Average Price (VWAP)?
In finance, volume-weighted average price (VWAP) is the ratio of the value traded to total volume traded over a particular time horizon (usually one day). It is a measure of the average price at which a stock is traded over the trading horizon.
VWAP is calculated by adding up the dollars traded for every transaction (price multiplied by the number of shares traded) and then dividing by the total shares traded.
Adding the VWAP indicator to a chart will complete all calculations for you. To calculate the VWAP yourself, follow these steps. Assume a 5-minute chart; the calculation is same regardless of what intraday time frame is used.
- Find the average price the stock traded at over the first five-minute period of the day. To do this, add the high, low, and close, then divide by three. Multiply this by the volume for that period. Record the result in a spreadsheet, under column PV.
- Divide PV by the volume for that period. This will give the VWAP value.
- To maintain the VWAP value throughout the day, continue to add the PV value from each period to the prior values. Divide this total by total volume up to that point. To make this easier in a spreadsheet, create columns for cumulative PV and cumulative volume. Both these cumulative values are divided by each other to produce VWAP.
Volume Weighted Average Price (VWAP) Vs Simple Moving Average
On a chart, VWAP and a moving average may look similar. These two indicators are calculating different things.
VWAP is calculating the sum of price multiplied by volume, divided by total volume.
A simple moving average is calculated by summing up closing prices over a certain period (say 50), and then dividing it by how many periods there are (50). Volume is not factored in.
Limitations of VWAP
VWAP is a single-day indicator, and is restarted at the open of each new trading day. Attempting to create an average VWAP over many days could mean that the average becomes distorted from the true VWAP reading as described above.
While some institutions may prefer to buy when the price of a security is below the VWAP, or sell when it is above, VWAP is not the only factor to consider. In strong uptrends, the price may continue to move higher for many days without dropping below the VWAP at all or only occasionally. Therefore, waiting for the price to fall below VWAP could mean a missed opportunity if prices are rising quickly.
VWAP is based on historical values and does not inherently have predictive qualities or calculations. Because VWAP is anchored to the opening price range of the day, the indicator increases its lag as the day goes on. This can be seen in the way a 1-minute period VWAP calculation after 330 minutes (the length of a typical trading session) will often resemble a 390-minute moving average at the end of the trading day.
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VWAP Indicator Explained
VWAP is a great technical indicator because it accounts for both price AND volume. Unlike moving averages, VWAP assigns more weight to price points with high volume. This allows you to understand price points of interest, gauge relative strength, and identify prime entries/exits.