Usually if a trader had to compare two seemingly good securities, an experienced trader would check both the price and the volume of the stock.
Now, you would ask, “Price is obvious, but why the volume?”
Volume is as important as the price because we don’t want to get stuck with a stock which has only a few takers, even if the price is too attractive. Thus, the VWAP was created to take into account both volume as well as price.
With VWAP as the measure of a trade, a potential trader would decide the long and short positions more accurately than if it were just the price taken into consideration.
Let us find out more about VWAP with this blog as it covers:
- What is VWAP?
- Formula of VWAP
- Application of VWAP in Excel
- Trading with VWAP – The interpretation
- How to use VWAP
- VWAP as a confirmation of trend
- VWAP as a trader execution strategy
- VWAP as an indicator
- VWAP as a check of profitability
- VWAP vs MVWAP
- Pros of using VWAP
- Cons of using VWAP
What is VWAP?
The volume-weighted average price, also known as VWAP, is the way to measure the average price of a financial instrument adjusted for its traded volume.
In simple terms, the Volume Weighted Average price is the cumulative average price with respect to the volume.
The Volume Weighted Average Price (VWAP) is simple to calculate and has a variety of uses. While a hedge fund or a mutual fund uses the VWAP to guide its decision to buy a substantial number of shares, a retail investor would use it to check if the price is good enough to go long.
Formula of VWAP
The formula for calculating VWAP is the cumulative typical price multiplied by total volume and divided by the cumulative volume. It goes as follows:
VWAP = (Cumulative (Price * Volume))(Cumulative Volume)
While the formula is quite easy, let us also find out the VWAP application in Excel by going through an example.
Application of VWAP in Excel
To calculate VWAP, we will take the minute level data of Amazon. You can get sample historical data from Alpha Vantage ⁽¹⁾. You may also read more ⁽²⁾ about how stock API providers such as Alpha Vantage adjust historical prices based on splits and dividends. We have used the data for the date 1st April 2022. A sample of the data is as follows:
Step 1: Find the average
To get a reliable estimate of the price at which a security was traded for a given period, we take the average of the price data, in this case, the average of the high, low, and close price.
Thus, the average price at 8:00 = (283.7374 + 3281.000 + 3281.000)/3 = 2,281.91
Similarly, for 8:01, the average price = (3284.9000 + 3284.9000 + 3284.9000)/3 = 3284.90
Step 2: Multiply the average price with the volume for that period and add the cumulative total of the previous period
Since we are looking for a period of 8:00, the volume traded was 300.
Thus, cumulative total of price at 8:00 = (Price * Volume) = 2,281.91*300 = 684573.
Since it was the first period of the day, it was a simple multiplication. From the second column onwards, we take the cumulative total, i.e. adding the previous period’s value to the current value.
Thus, for 8:01, with volume at 250, the cumulative average price = ((Average price at 8:01) * volume at 8:01) + cumulative total at 8:00
= [ 3284.90 * 250] + 684573 = 15,05,798.
Step 3: Find the cumulative total volume
Since we found the cumulative average price * volume, we have to keep a running total of the volume of the security traded.
Hence, for 8:00, it will just be 300 as it is the first period of the day.
For 8:01, it will be (Volume at 8:01) + cumulative volume of the previous period, i.e.
(250+ 300) = 550.
Step 4: Find VWAP
We simply divide the cumulative price * volume by the cumulative volume.
Thus, for 8:00, VWAP = 684573 / 300 = 2281.91
For 8:01, VWAP = 15,05,798 / 550 = 2737.8145
It will look something like this in Excel:
|Date||Open||High||Low||Close||Volume||Average price||Average price * Volume||Cumulative volume||VWAP|
Trading with VWAP – The interpretation
With VWAP, the trader gets the integral information regarding the stock’s price movement that helps them determine the best entry point.
For instance, a trader waits for the price line of a particular stock to go above the VWAP line. In case there is a lot of selling (short positions) in the market for that stock, the stock may fail to break above the VWAP line.
This is because the stocks above VWAP line are considered to be expensive and hence, are at a high value. When the stock price is rising to go above the VWAP line, it implies that lot of traders are buying the stock. This is when the traders go long before the price reaches its peak.
On the other hand, the stocks below VWAP line are known to be undervalued and trend downwards making the traders go short on such stocks.
With the help of trend lines (support and resistance lines) and candlestick pattern (representing price movement), a trader can find out when the stock moves above or below the VWAP line.
Visit QuantInsti for additional insight on this topic: https://blog.quantinsti.com/vwap-strategy/.
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Disclosure: API Examples Discussed
Throughout the lesson, please keep in mind that the examples discussed are purely for technical demonstration purposes, and do not constitute trading advice. Also, it is important to remember that placing trades in a paper account is recommended before any live trading.
Disclosure: Hedge Funds
Hedge Funds are highly speculative, and investors may lose their entire investment.