Topic 22: VWAP Explained (VWAP)

Content Type: Text lesson + 5:54 video

Text Content

Have you ever heard of the VWAP? No? I'm going to explain all about it to you now. I don't use the VWAP very much myself, but I have noticed that it can help a lot of traders. So let me explain to you what exactly it is and how you can use it.

VWAP stands for Volume Weighted Average Price. The reason it is so popular is because it is the benchmark by which trade execution is measured. It is the average price at which the majority of a given period's trading took place weighted by volume at each price level. In other words it means to fill a trade where everyone else is trading.

A broker can add value by processing an order in discretion. By buying when they thought the price was low and selling when they thought the price was high. And that is based on their judgment of the market. The VWAP is a good replacement for that. Because if an institution wants to place a large order that needs to be filled, they often use a VWAP-based algorithm. To execute the order as close to the VWAP as possible. Hedge funds are well aware of their impact on the market and know full well that they are moving the market with their orders.

To put it simply, the VWAP is used to determine the value for institutional traders about the same as a moving average works as a trading indicator. But a VWAP is used more for an analysis than for an entry. When a buy order is executed at a price that is better than the VWAP, it is good for the trader because the trade value is better than what everyone else in the market has received during that period. And of course the same goes for when someone sells. The VWAP is therefore the benchmark for large orders!

When the price is below the VWAP, institutions willing to buy will tend to buy at prices below the VWAP. And vice versa, of course. If an institution tries to fill an order, they will not be willing to do so if the price is still above the VWAP. They can buy some in case the price never comes back but it will be minimal. The strange thing about it is that there is no guarantee that it will be filled or that it will match the VWAP.

And now you wonder why do I have to learn about the VWAP then why is it important anyway? Well that is because we can see with it whether we might be buying too expensive or selling too cheap. Let me give an example imagine if the price goes up 1 or 2 points above the VWAP and you buy then you could be buying it way too expensive. And vice versa, which of course also means that the price is 1 or 2 points below the VWAP and you want to sell that could also be too cheap. This is not to say that the price cannot move 3 or maybe 4 points away from the VWAP because that is of course possible.

When trading order flow, you could therefore use the VWAP to determine whether you are buying or selling too high or too low at that moment. For example, you could only look for buy opportunities when the price is low and sell opportunities when the price is high.

VWAP Image

VWAP Example

Above you see an example of the VWAP. The red/green line is the average of the VWAP. After that, the VWAP was divided into several parts.

And don't think that the VWAP has to go back to the average. In a trending market, the VWAP can hover above or below it for quite some time.

Key Rules:

Bullish day: Price will mostly hover above the VWAP.
Ranging day: The price remains around the middle of the VWAP.
Bearish day: Price will mainly hang below the VWAP.

On days when important news comes into the market late in the day, that cause significant price movements on heavy volume the VWAP profile will be affected.

Recommendations

Only use the VWAP to determine where we are in the market — for that it can be a very useful tool.
You definitely shouldn't use the VWAP as a moving average because that's something completely different.

Key Takeaway for Bot

VWAP = institutional benchmark for order execution
Price below VWAP = institutions looking to buy = potential long bias
Price above VWAP = institutions looking to sell = potential short bias
Use VWAP as a filter: don't buy 1-2 points above VWAP, don't sell 1-2 points below
VWAP is for ANALYSIS, not entry signals