Understanding Volume Weighted Average Price (VWAP) and How to Use It

VWAP is an intra-day calculation used primarily by algorithms and institutional traders to assess where a stock is trading relative to its volume weighted average for the day. Day traders also use VWAP for assessing market direction and filtering trade signals. Before using VWAP, understand how it is calculated, how to interpret it and use it, as well the drawbacks of the indicator.

Calculating VWAP

To understand VWAP, let’s look at its inner workings. VWAP overlays the price data, and shows the average price of the day, weighted for volume.

Institutions often base VWAP on every single tick of data that occurs during the trading day. Calculating VWAP based on other time frames, such as 1-minute or 5-minute price bars is also acceptable, and is how most chart platforms such as FreeStockCharts.com or StockCharts.com compute the indicator.

Calculate VWAP using the following steps:

• Pick what period you’ll use as your input, 1-minute price bars, 5-minute price bars, etc.
• For each bar take the High + Low + Close and divide by 3. This gives you a “typical” price for that period.
• Multiply the typical price of that period by the volume for that period, to get the Weighted Price.
• Keep a running total of the Weighted Price, as well as a running total of volume as new data becomes available (a period ends). These are called Cumulative (or Total) Weighted Price and Cumulative Volume respectively.
• To get the VWAP, divide the Cumulative Weighted Price by Cumulative Volume.

Be sure to also read our Ultimate Guide to Analyzing Trading Volume.

VWAP Uses and Strategies

VWAP starts at the open price, and then moves up or down based on price movement and volume.

VWAP eliminates much of the noise seen in a stock throughout the day, even more so than a moving average would. At the start of the day the VWAP is more sensitive to price moves, but as the day progresses it becomes less so. This is because it’s based on cumulative values, so as these values get larger toward the end of the day, each new piece of data has less and less effect on the VWAP.

All charts courtesy of FreeStockCharts.com

VWAP Applied to Stock Chart
Figure 1. VWAP Applied to 1-Minute Chart of AAPL

When the price is below the plotted VWAP values the trend is likely down, or there is a downward bias to the trading day. Institutions looking to buy will often try to buy when the price is below VWAP, as they are able to accumulate a position at a better than typical (VWAP) price.

Short-term traders usually do the opposite, interpreting the price below the VWAP as bearish, and looking for short positions.

When the price is above the plotted VWAP, the trend is likely up, or there is an upward bias to the trading day. Institutions looking to sell or short will often try to sell when the price is above VWAP, as they are able to accumulate a short position or dump shares at a better price than what has been typical so far in the day (VWAP). Short-term traders usually do the opposite, interpreting the price above the VWAP as bullish, and look for long positions.

VWAP is a guide and a source of price information that reduces market noise. It does not provide entry signals, stop loss levels or target prices.

Figure 2 shows how an institution looking to accumulate a position (buy) or dispose of a position (sell or short) would view its transactions relative to VWAP.

Institutions interpreting VWAP
Figure 2. How Institutions Use VWAP as a Benchmark for Trades on M 1- Minute Chart

Figure 3 shows how retail traders use VWAP in helping them decide whether they should be focused on finding long or short trade opportunities as the day progresses.

Learn more about How to Spot and Trade Trend Reversals.

Retail traders utilizing VWAP
Figure 3. How Retail Traders Utilize VWAP on M 1- Minute Chart

On strong trending days the price will be above or below the VWAP for much of the day. On ranging days the VWAP will run through the middle of the price action, showing the overall sideways direction of the price. This can help retail traders determine what type of strategy they should be utilizing, trending strategies or ranging strategies.

VWAP Limitations

Unlike a moving average, which is commonly used in the development of trading strategies, the VWAP is more of an analysis tool than a trade signal tool. It provides a basic guide for whether there’s an upward or downward bias in price, but the actual VWAP line isn’t likely to provide consistently good trade signals. This is mainly because during strong trending moves the price is unlikely to touch (or even come close to) the VWAP.

Later in the trading day, the “lag” in VWAP becomes significant. This is because so much data is already being computed into the calculation that new data points have very little effect. Therefore, VWAP is of more value at the start of day to retail traders because it is more responsive to price moves. On the flip side, at the end of the day the VWAP will flatten out and be of little use to the retail trader. The end of day VWAP values are more important to the institutional trader though, since the end of the day VWAP value gives a benchmark that the institution can compare their transactions to.

The Bottom Line

VWAP gives the typical price of a stock (so far in the trading day), based on price moves and volume. It’s an intra-day indicator, starting with the first period (based on chart time frame chosen) of the day, and ending with the last. VWAP doesn’t provide trade signals like many other indicators; it’s an analysis and benchmarking tool. As the day progresses the VWAP begins to lag more and more. Therefore, retail traders find it more beneficial early in the trading session, and institutional traders find it more beneficial toward the close.

Cory Mitchell