As an investor in the stock market, you can reference loads of data and use a bunch of tools to help you identify wealth-generating bets. If you are more of a fundamental type of investor, you are primarily concerned with the underlying company’s growth in revenue and profits. In that case, you can refer to annual reports, management interviews, brokerage reports, and valuation ratios to spot lucrative investment opportunities. On the other hand, if you wish to be a trader or have more of a technical approach, you are meticulously following the stock’s price. Here, you can use several technical indicators to help you track the price and time of your entries and exits.
This article will cover a technical indicator called the volume-weighted average price, or VWAP indicator. We will learn what it is, how to calculate it, and how to use it to trade in the stock market.
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What Is the Volume-Weighted Average Price (VWAP)?
The volume-weighted average price, or VWAP indicator, is a technical indicator widely used by both retail traders and mutual fund managers. It takes into account the trading volume and price of a stock throughout the trading day, and based on that, it portrays the average price of the stock. It helps traders comprehend the trend and value of the stock or asset.
Retail traders generally apply this indicator on intraday price charts, which makes the VWAP a popular indicator among intraday traders. However, retailer traders, who are not intraday traders, may also reference this indicator to predict the future price trajectory of the asset. On the other hand, mutual fund managers use this indicator before purchasing a large volume of a specific stock. It helps fund managers discard the distortion caused by volatility and determine a fair price to make buying or selling decisions.
Calculation of Volume-Weighted Average Price
As a retail investor, there is no real need to calculate the volume-weighted average price today. All you have to do is open a price chart on the Share India app, and with a few taps, add the VWAP to the chart. However, it will only benefit you if you know how the VWAP is calculated, as it will help you understand the indicator better. So, let us learn how to calculate the VWAP in the following section.
Like any other technical indicator, the VWAP indicator is also derived using a mathematical formula. The calculation of the indicators starts with the opening bell and ends with the closing bell of the market. As the indicator is primarily an intraday indicator, intraday data is taken into account to calculate it. With that, the formula to calculate the VWAP comes to be:
VWAP = Cumulative Typical Price*Volume/Cumulative Volume = Cumulative TP*V/CV
Here, the typical price is nothing but the average of the high, low, and closing price of the asset, and cumulative refers to the total since the session opened. Keeping that in mind, the formula for the typical price is:
Typical Price (TP) = (high price + low price + closing price)/3
On the other hand, the Cumulative Volume (CV) is the total volume since the trading session opened, while Volume represents the volume(V) traded at a particular point. The VWAP indicator on a price chart results in the formation of a smooth curve, as you can see in the diagram below.
How to Interpret a VWAP Indicator
Now that you know how VWAP is calculated, let us learn how you can interpret it. For that, let us refer to the following 5-day chart with 15-minute candlesticks (red and green bars) of TCS (Tata Consultancy Services). We are rendering to a 5-day with 15-minute candles since VWAP is generally applied to intraday charts. You can even apply it to other intraday charts with candlesticks that span for seconds, minutes, or hours.
That said, in the above chart, the VWAP indicator is represented by the bright blue or turquoise colour curve or line. Since the indicator also accounts for volume, it will help pinpoint the points of interest on the chart. At those points of interest, there may be a lot of buying or selling activity. When there is a steep line heading upward, there is heavy interest on the buying side. In contrast, when there is a steep slope downward, it indicates heavy selling activity is taking place, as you can see in the above chart.
Trading Strategy with VWAP
Besides showing you the points of interest, you can look at the volume-weighted average price to find the predominant trend of the asset or even the market. When the price is above the VWAP indicator, a bullish sentiment is prevailing. Otherwise, when the price is on the other side of the indicator, i.e., below the indicator, the market is bearish.
Now that you know how you can use the VWAP to identify the trend, you can also consider making trades based on the relationship between the indicator and the price. If the price drops above the VWAP line, a trader can consider taking a long position. In comparison, when the price breaks under the VWAP line, a trader may consider taking short positions. Depending on whether the price is above or below the line, the line can also act as a support or resistance line.
As a result, you can use the volume-weighted average price to confirm the trend and find the best entry and exit points. Institutions like mutual funds and insurance companies make transactions by buying under the indicator and selling assets when the price cuts above it to minimise the impact of their transactions on the market.
Conclusion
The volume-weighted average price is a useful tool you can refer to as a technical trader. You can make your trades based on the indicator or construct other strategies around it. You can also combine it with other technical indicators to come up with a strategy. However, remember that, by all means, you still have to follow stringent risk management practices. No matter the indicator, there is always a chance of the trade not panning out as expected.
