What is and how is the VWAP used?

When we talk about trading and technical analysis , one of the indicators that is most used by professionals is the VWAP due to the high information it provides in terms of market liquidity. 

But what is the VWAP indicator? , How is it used? And above all, with what strategies can it be combined? In this post we give you all the keys to one of the favorite indicators of finance gurus .

What is the VWAP (pronounced VIWAP)?

In finance, the Volume Weighted Average Price (VWAP) is the ratio of the value of a traded financial asset to the total volume of transactions during a trading session. It is a measure of the average trading price for that specific period.

Normally, the indicator is calculated for one day , but it can be measured between two different moments.

The VWAP - Volume-weighted average price - is often used as a trading reference by investors who want to be as passive as possible in their execution. Many pension funds and some mutual funds fall into this category. The purpose of using a VWAP trading target is to ensure that the trader executing the order does so in line with market volume.

It is sometimes argued that such execution reduces transaction costs by minimizing market shock costs (the additional cost due to market shock, i.e. the adverse effect of a trader's activities on the price of a security). ).

The VWAP is often used in algorithmic trading. A broker can guarantee the execution of an order to the VWAP and have a computer program enter the orders into the market to earn the trader's commission and create P&L (“Profit and loss”). This is called guaranteed VWAP execution. The broker can also operate in the best possible way and respond to the client with the realized price. This is called a VWAP target run; incurs a greater dispersion in the response price compared to the VWAP price for the customer, but a lower commission received/paid. Trading algorithms that target VWAP belong to a class of algorithms known as volume share algorithms.

Digesting all this is quite complex, so we are going to try to explain it so that ordinary mortals can easily assimilate it.

In short, the VWAP is a tool used by trading professionals to make decisions more efficiently.

Why use the VWAP indicator?

In very basic terms, there are three things you can do when trading: Sell, Buy, or Wait .

The derivatives that come out of the VWAP have the utility of combining price and volume to make the most beneficial decision . In other words, decide if you have to sell, buy or, better, wait.

We all understand as logical that the most appropriate strategy is to buy low and sell high, correct? The difficulty lies in knowing with certainty when a security is expensive or cheap . Therefore, the main reason for using the VWAP is that it provides us with certain information to act with sufficient guarantees of success.

Now we are going to see how the VWAP can help us to specify the real risk effectively. The VWAP is the actual information coming from the market during that exercise. It is understood that it is based on approximately 70% (68.27%) of all transactions that have occurred up to that specific moment .

When we find the price that has the largest number of trades - trade thickness - then we can decide if the market is overbought or oversold compared to its current and average price. 

What is the formula of the VWAP indicator?

The VWAP is calculated (automatically) by taking the average of the high, low and close of the time period and then weighting that average price by the total volume traded in that period. As the day progresses, it is necessary to keep updating the formula for each time period to get the VWAP line throughout the day. 

 

Trading strategies with the VWAP indicator

Since VWAP is such a popular tool used by carriers, it can often have self-fulfilling prophecy characteristics. If a stock is trading higher but still below the VWAP, traders can anticipate the test of the VWAP and enter a long position targeting the VWAP. As traders get on board trying to get ahead of the next trader, the stock can naturally move towards the VWAP. 

On the other hand, bear markets expecting a rejection on the VWAP may place their limit orders to short the stock on the VWAP, hoping for profit takers and more sellers. 

The VWAP is most useful when combined with other indicators or a trading methodology.

We must remember that current financial markets move so quickly that movements must be analyzed from different perspectives.

Strategy 1: Use the VWAP as Support/Resistance

One of the easiest uses of the VWAP is to gauge support and/or resistance. It is a simple line (VWAP) that acts as support if the stock is trading above it and as resistance if the stock is trading below it. The direction of the VWAP line is the indication of the trend, so it is used as a “de facto” trend line. 

Strategy 2: Use the VWAP as entry and exit levels

One trader's support is another's resistance. In other words, a trader who is long can use the VWAP as an exit target if it trades below it. Traders wishing to take a long position can wait for the stock to break through the VWAP for longs or pull back and bounce off the VWAP on pullbacks. The VWAP is a good entry and exit zone. If you also have the accompanying upper and lower envelopes, these can be used to pull back into the VWAP.

 

Strategy 3: Use the VWAP to measure relative strength

A stock that trades above the intraday VWAP may be bullish, while a stock that trades below it may be bearish. A quick look at the chart immediately gives you an indicator of relative strength or weakness . When you combine VWAP readings from benchmark indices and peer stocks, you can compare and gauge whether the stock is showing relative strength or weakness. It also allows you to think more carefully about your operation.

For example, shorting a stock that is in an uptrend and trading above its VWAP makes you susceptible to a short “squeeze” since you are trading against the trend. Conversely, if you short a stock that is trending down and trading below the VWAP, you can trade relative weakness in line with the trend. 

Strategy 4: Operate with a 'crossed' VWAP

When the underlying share price crosses the VWAP from below, it can represent a breakout. This may be a signal to go long on the stock. If a stock falls below the VWAP, it could be a short-term sell signal as it is broken. The VWAP is also a good stop zone if support is broken . For example, you can plan to enter XYZ on a break through $27.10, which is the VWAP, and place a trailing stop of $0.20 below the VWAP. This allows you to design a quantifiable “action plan” for your operation. Remember that the VWAP works best when combined with complementary indicators , especially momentum indicators . 

Used by institutions

Institutions and fund managers can use the VWAP to measure the quality of their orders. If the orders are consistently filled above the VWAP, the manager may look for other market makers or traders to fill the orders. 

Institutions may want to enter a position, but the price at which they enter may have an impact on the market. The VWAP is also used to measure the liquidity and market impact of institutional orders. 

If the trader executes the orders recklessly, the stock will rise, triggering an element of chasing the fills and a possible sharp fall once the orders have been filled. 

There are many ways to operate with the VWAP. Again, it works best when combined with other complementary indicators, including momentum indicators like the MACD or stochastic . 

How to use the VWAP in metatrader 4/5?

The VWAP (Volume Weighted Average Price) is an advanced technical indicator freely available for the metatrader 4 or MT5 trading platforms . It is plotted directly on the graph for an easy-to-read visual representation of complex math. 

Forex trading strategies have also started incorporating the MQL4 VWAP indicator into their analysis. I must stress that it is most effective for day trading Forex. Long-term strategies do not benefit as much from what the VWAP indicator indicates.

Let's imagine that we wanted to analyze the price of the EUR/USD currency in the last few hours to decide whether to execute a trade or not. 

What we would do, would be to open a simple moving average indicator on the hourly chart and configure it to calculate a simple average of the last five hourly closing prices. 

Let's say the closing prices had been: 1.1000, 1.1010, 1.1020, 1.1030 and 1.1040, the indicator would show the average price as 1.1020 (the sum of each of the five values, divided by five). 

Now let's compare that to the VWAP applied to the same asset and configuration. The VWAP will read volume data showing how much EUR/USD was bought at each of the five prices and give a higher weight to the prices where the most volume was traded. 

For example, that almost all the volume, during that time, has been traded at 1.1000. The VWAP will then show an average price very close to 1.1000, much lower than the price shown by the simple moving average, which is only interested in price and time, with each price receiving equal weighting in the average calculation.

The VWAP provides a more accurate indicator as it reflects the actual price. In technical analysis, volume remains a variable that tends to be very important in confirming trends, trend reversals, supports, resistances, breakouts, and breakdowns. Since the VWAP uses it in its formula, it is more reliable and useful than moving average indicators.

The VWAP indicator is more popular with equity traders because volume data for stocks is available with every trade, and many online resources provide end-of-day volume data for free. 

In the forex market, volume is more complex and usually not as readily available, given the decentralized nature of forex trading. 

This can make the VWAP more difficult to apply in the Forex market, although some Forex traders believe they have found a way around it by using tick volume instead of actual volume data as the volume input. 

Although some analysts criticize this practice, there are studies that show a positive correlation between actual volume and tick volume in the forex market . More and more Forex brokers are making their own real volume data available to their clients, so sometimes the indicator can connect to them, although some still prefer to use tick volume.

Breaking the VWAP usually "gives" a lot of volume.

How to use the VWAP indicator?

In the long run, it can also be helpful.

The rise of algorithmic trading and the popularity of short-term strategies made the VMAP indicator one of the most popular technical indicators among retail traders. It is not very suitable for trading strategies in the medium and long term, but there are two ways to use it in the higher time frames:

The VMAP can suggest good entry and exit levels by confirming support and resistance levels . Basically, when the VWAP shows unusually high volume, it may become a good support or resistance level. I recommend using other technical analysis tools to identify the medium to long term trend itself.

Using a VMAP Moving Average, also known as MVMAP, provides a moving average of a moving average and can give mid- to long-term traders a “better understanding”—of true value—than a simple VWAP.

VWAP in short-term operations

The first thing I recommend is to adjust the VWAP indicator settings . The default setting shows the daily, weekly and monthly VWAP. Since we are going to be trading the VWAP in the short term, those time frames are not suitable. 

We will use the MT5 platform as an example below, as VWAP is more popular with MT5 users than MT4 users:

However, before you start investing in such a short term, I recommend that you read this article on the extreme discipline required in volume trading .

Possible VWAP configuration:

1. Double click on the VWAP indicator on the MT5 trading platform.
2. Double click on “Enable_Level_01 false”. It will change to true.
3. The default value for the short period is 5 time periods. 
4. Double click on “Enable_Level_02 false”. It will change it to true.
5. The default value for the long period is 13 time periods. Adjust to the period you prefer.
6. Click OK.

Since the VWAP works like the moving averages, it is efficient to find the crossovers and trade with the trend. More accurate trading signals can also be found when they occur if used in conjunction with the daily VWAP as a multi-time frame analysis.

I recommend looking for long entry signals when VWAP X (first value) crosses above VWAP Y (second reference value) if price action is bouncing off support levels. I wait for the candlestick to close above both and enter during a pullback. Or breakout above the daily VWAP after VWAP X crosses above VWAP Y. 

Is the VWAP indicator reliable?

Yes, but cautiously. Actually, it depends. It is a relative indicator and as we have repeated here, it is necessary to combine it with other indicators to be better informed when making the relevant decision.

In the 10K reports from GoldmanSachs or JPMorgan , (which everyone can consult), we can see that the VWAP appears regularly.

The general belief among professional and non-professional traders is that a sufficient number of institutional traders use the VWAP as a reference. Traders often believe that the recognition of these dynamics should be included in the strategy of negotiation (trading).

But being a summary version of a single day, the VWAP has no real effect in making predictions or calculations for the future, except in the case of "guessions". 

Our recommendation from Rankia is that it be used together with other indicators. You know, safety first.

In any case, if you are going to start trading in the short term, I recommend that you first read this article where you can find the best platforms for trading , so that in your technical analysis you can combine the VWAP indicator with any other. 

What indicators work best in combination with the VWAP?

The 7 indicators that we suggest from Rankia, for intraday trading:

• VWAP (Volume Weighted Average Price)
• EMA (Exponential Moving Average)
• Supertrend Indicator.
• ADX (Average Directional Index)
• OBV (On Balance Volume)
• Donchian Channel.
• CPR (Central Pivot Range)

And as always now it's your turn. Do you usually use the VWAP indicator ? What strategy do you apply to it? And what other indicator do you combine it with? I read you in the comments.