VWAP Tutorial: Calculation, Uses, and Limitations – Part I

QuantInsti

Contributor:
QuantInsti
Visit: QuantInsti

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:

DateOpen HighLowCloseVolume
2022-04-01 08:00:003281.0000283.73743281.00003281.0000300
2022-04-01 08:01:003284.90003284.90003284.90003284.9000250
2022-04-01 08:02:003284.90003284.90003284.90003284.9000100

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:

DateOpen HighLowCloseVolumeAverage priceAverage price * VolumeCumulative volumeVWAP
2022-04-01 08:00:003281.0000283.73743281.00003281.00003002281.916845733002281.91
2022-04-01 08:01:003284.90003284.90003284.90003284.90002503284.915,05,7985002737.8145
2022-04-01 08:02:003284.90003284.90003284.90003284.90001003284.918,34,1983505240.565

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/.

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from QuantInsti and is being posted with permission from QuantInsti. The views expressed in this material are solely those of the author and/or QuantInsti and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

In accordance with EU regulation: The statements in this document shall not be considered as an objective or independent explanation of the matters. Please note that this document (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and (b) is not subject to any prohibition on dealing ahead of the dissemination or publication of investment research.

Any trading symbols displayed are for illustrative purposes only and are not intended to portray recommendations.

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.