In today's article, we will see the VWAP trading strategy. The VWAP stands for Volume weighted Average Price. Price, volume, and time are the three major components of this strategy. Time is subjective among these three, as some traders might be swing traders, while others might fall under intraday trading.
This strategy is very popular and used by almost every person, whether a new investor or one with experience in the stock market.
The working of the strategy is very simple, take a daily volume of the stock and divide it by the amount traded; this calculation will give you the average price of the underlying stock in a specific time frame. This average value obtained helps the traders to determine whether the stock is overpriced or underpriced.
Based on this information, traders also identify the entry and exit points. Further, the same data can also be helpful in obtaining potential breakout and reversal points. Thus, it can also be seen as the benchmark that compares the executions of the trades in different time frames.
The strategy mainly uses Intraday data for the calculations. We can also call it the ratio of cumulative stock price to the cumulative volume traded in a given time frame.
We shall provide you with in-depth knowledge on how you can utilize the VWAP stock trading strategies in your favor. Further, we shall also learn the importance of volume and various VWAP trading strategies.
Some of the basic things you should know about VWAP strategy:
It is a very basic indicator that is understood by everyone easily.
It is generally used for finding the entry points and exit points in the trade, along with the potential breakouts and reversal points.
To get the average, traders must get the total volume and divide the same by the amount traded in that time frame.
The time frame to calculate the average is 24 hours, but it can be changed to weeks or months.
The VWAP is not necessarily only for active traders but also for passive traders. Passive traders can also see the potential profit and enter at that point.
Combining this average with other indicators, such as MACD (Moving Average Convergence-Divergence) and RSI (Relative Strength Index), will make your strategy more effective.
Why Volume is important in this strategy:
It indicates how actively the stock is traded in the market. As we have seen, traders must get the total volume first to get the average value. Thus, the more volume you have, the more efficient it will perform.
We shall understand this with an example.
Calculating the VWAP opening price of the day is taken with some adjustments until the end of the session because it considers the intraday data only.
The formula is as follows:
VWAP = (cumulative price X Volume) / cumulative volume
The calculation starts with getting the cumulative price from the chart of your time frame. Suppose we take a 5 min chart; this will be the first five-minute bar or candle. You have to take the candle's higher price, lower price, and closing price.
Let's assume, the higher price is ₹45, the lower price is ₹43, and the closing price is ₹44.5. So, the cumulative price will be
= (45+43+44.5)/3
=132.5/3
= 44.16
Next, you have to multiply it by the volume, assuming the volume is 30,000, then it will give;
=44.16 X 30,000
=13,24,800
Continue ahead with the example; suppose the second candles average is 42 and the volume is 35,000; it will give;
42 X 35000
=14,70,000
The VWAP after the second candle will be:
1324800 +1470000 /75,000 (total volume of both candles 30,000+35,000)
=37.26
The VWAP keeps running these calculations for every candle and their related prices throughout the day to provide you with the current VWAP value in real time.
So, we have seen how important volume is. Your VWAP calculations will not be accurate enough if the stock has a low volume.
Ensure you are trading in a financial instrument with a good amount of volume because the low volume calculations will lead to uncertain situations.
How to identify the potential entry and exit points?
We have seen that the VWAP Trading strategy is one of the great ways to identify the trader's potential entry and exit points, but the question is where to look.
At the time of buying any security, wait for the price to break above the VWAP line, then check other indicators for confirmation of whether that point suits your trading plan and goal.
In the same way, while selling any security, you have to allow the price to break below the VWAP line and check the other indicators to be extra sure.
As the stock market is uncertain and no predictions, analysis can be 100% true, thus you should always be prepared with risk management strategies if the market turns against you.
The closer you are to the VWAP line, your risk increases, as it can break through anytime and put you on the wrong side of the trade.
Using VWAP for Range Bound trading:
One of the best ways to make good use of the VWAP strategy is to use the Bollinger Bands that accompany it. These bands are usually X amount of standard deviation from the VWAP line. Sometimes, these bands can lead to excellent short-term signals to profit.
If you want to try this strategy for a longer timeframe, you need to make separate and strong risk management strategies for them.
A few VWAP trading strategies:
The VWAP Pull back strategy:
This can be implemented on a 5 min chart.
When the price closes below the key indicator, traders use this strategy to short.
A few traders wait for the first couple of candles and wait to get a pullback, to enter the trend.
Fade to VWAP strategy.
It is a great strategy to determine the risk and rewards of your position.
This strategy can also be used along with the Bollinger bands.
VWAP Hold and Go strategy:
When this type of chart pattern is created, the probability of success is very high.
The volume of the underlying stock plays a vital role in the confirmation
This is just a brief detail of different VWAP strategies used in the stock market. Let us move on to understand some basic points you must know before implementing the VWAP trading strategies.
For multiple time frames, you need to make multiple strategies, as one strategy does not fit well in all time frames.
Timeframe does play an important role; the higher the timeframe, the more accurate and reliable the indicator will be.
Though VWAP is the best indicator for support and resistance levels, it can perform better if combined with other indicators.
As said many times, volume is the key to success. If the security you are trading does not have enough volume, you will get false signals.
Lastly, to conclude this article, we have seen how VWAP is the best strategy for both new and expert traders. This indicator has many usages in different types of markets. We also saw how important the volume factor is; to get the perfect results. To get the optimum out of it, always use some other indicators as the standalone may not be as reliable.
Lastly, in order to use VWAP, you must have strong risk management strategies and a good risk appetite.
I hope you liked the details we shared about the VWAP.