What is Volume Weighted Average Price (VWAP)
By Brandon Wendell | November 21, 2019
Volume Weighted Price Average (VWAP) is an indicator used by institutional traders to help determine a price range where they want to place their trades. As the name indicates, it is based on the average trading price weighted by volume of trades for the current day. This indicator can also be used by non-institutional traders as an odds enhancer for investing and trading. Let’s examine why and how to use volume weighted price average.
Working the Order and VWAP
When institutions look to buy or sell in the financial markets, they are typically doing it in a large quantity. In order to not disturb the delicate balance between demand and supply, they must break their orders into smaller pieces so they can buy and sell unnoticed. This action is called, working the order. Volume weighted average price (VWAP) is the indicator the institution uses to make sure they are getting a good average price for their security.
Example of Working the Order
Looking at a common stock like Apple (AAPL), the first sample chart below shows that the average daily volume is quite large, at just over 25 million shares traded per day. However, when you break this down to a five-minute timeframe, as can be seen in the second sample chart below, the average volume traded every five minutes drops to only 114,000 shares. Let’s imagine that an institution wanted to purchase two million shares of AAPL. If they were to place the order for the full number of shares, the market would see the huge demand created by the buy order and prices would likely jump up very rapidly as there are not enough sellers to satisfy the order.
Also, since there are rarely any orders placed larger than a few hundred shares, as can be seen by looking at the sample Market Depth chart, commonly known as Level 2, below, if an institution were to place a large order, it would attract unwanted attention and the sellers would retreat to higher prices. Other buyers would wonder why someone wanted to buy so much stock and they would likely front-run the large order. Front-running is where orders are placed at a slightly higher price than the previous ones to get filled first. Orders are filled on a first come, first served basis and based on price. The best price gets the shares. If an institution placed a large order, they would likely not get their order filled as others would front-run them and drive prices higher.
So, to get a large position filled in any security, the institutions will identify a price range where they are willing to enter and then work their order by placing a series of small orders within that price range. Should prices leave the range, the institution will simply wait until it returns to complete their position. This waiting could be a few minutes or as long as a few years.
How to Use VWAP in a Trading Strategy
We know the institutions want to make money buying low and selling high. The question then becomes, where is low and where is high?
Volume weighted average price can help answer this question and can be found on most trading platforms either as a number or a line drawn on the chart, as show in the sample image below. Since VWAP is a benchmark price based on the prices and number of shares traded throughout the day or, said another way, it is the average price traded based on the total number of shares traded, it indicates the average cost for most traders that day. So, when an institution is looking to purchase a large number of shares they will attempt to buy them under the VWAP by making several smaller trades over a period of time. A similar process applies when they want to sell shares, they will try to sell at prices above VWAP.
So how should a trader or investor incorporate the VWAP into their strategies?
VWAP Can Help Identify the Trend of a Security
The VWAP can be used in two manners. The first is to help identify the trend that the security is currently in. If the candles on the chart are closing above the VWAP, then the security is likely in an uptrend. If the closes of the candles are below the VWAP, the downtrend is in place. To view this the VWAP indicator can be applied to intermediate time frame charts.
Using VWAP to Add Strength to a Supply or Demand Zone
The second manner is to use the VWAP to add strength to the supply or demand zones identified as trading opportunities. The best time to use the indicator would be midday or in the last hour of the trading day. This is the time where prices will typically return to the VWAP as the institutions attempt to fill their orders at prices better than the average.
Moving Volume Weighted Average Price (MVWAP)
An additional indicator that is sometimes used is the Moving Volume Weighted Average Price or MVWAP. While the VWAP is a one-day calculation, the MVWAP shows traders the average over a period of time. This is the same as a moving average for price but uses the VWAP from each day instead of closing prices for the input.
The advantage of the MVWAP for longer-term traders is that it smooths out the price action and can prevent traders from getting caught up in short term price swings when determining the trend. While the VWAP can be used intraday, the MVWAP is for longer term trend identification and trading.
Mutual fund and hedge fund traders will often apply this strategy, placing their orders late in the day so that they can observe the trading activity throughout the day and get a better than average price. Now that you know one of their secrets, you too can look to beat the average.
About the Author
As a former stockbroker, brokerage trader, and hedge fund trader, Brandon Wendell brings various market views and insight to trading classes and articles. Brandon has been trading equities, options, Forex, and futures in his own account since completing Online Trading Academy courses in 1998. He enjoys sharing his knowledge because it gives him an opportunity to help others in their quest for financial freedom.
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