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Technical analysis is a trading discipline. Traders evaluate historical data, such as prices and trading volume, using different techniques to make predictions about future performance. As part of their strategy, technical analysts take the data to find trends and momentum as well as entry and exit points by using different tools like indicators and oscillators. In this article, we look at the
volume-weighted average price (VWAP) and what makes it so important to technical traders.
Key Takeaways
- The volume-weighted average price is an indicator used by technical analysts.
- It is used to track a security’s average price and trading volume on intraday charts.
- Many traders believe that the VWAP represents a security’s true average price.
- Despite being a lagging indicator, the VWAP helps traders identify entry and exit points and whether to take an active or passive approach.
What Is the Volume-Weighted Average Price (VWAP)?
The volume-weighted average price is an important tool that traders use to track the average price and volume of a security over a certain period. Traders and analysts typically use the standard VWAP, which calculates the price based on all of the orders for the trading day; however, some prefer to use multiple time frames for the VWAP.
This indicator is generally used on intraday charts. It resets itself whenever a new trading session begins. As a technical indicator, the VWAP is representative of the average price a security trades at throughout the day based on its volume and price.
To calculate the VWAP, traders first multiply the price (since the opening of the trading session) by the trading volume. That result is then divided by the total shares that are traded. The formula is noted below:
VWAP = (Typical Price x Volume) ÷ Total Shares Traded
The typical price in the formula for the VWAP is the sum of the high, low, and closing prices divided by three or (High Price + Low Price + Closing Price) ÷ 3.
The VWAP also helps traders establish support and resistance levels suitable for intraday trading.
Importance of Volume-Weighted Average Price (VWAP)
Traders use the VWAP to combine price and trading volume and make important decisions about whether to make an entry or exit point in a specific security. They are also able to use it to determine which type of approach to take—active or passive if they decide to go ahead and make an entry.
Many technical traders believe that the indicator truly represents a stock’s average price. The VWAP helps to eliminate any noise that occurs throughout the day, allowing traders to gauge what prices other market participants are trading at on the stock or the market. Put simply, VWAP gives traders insight into how a stock trades for that day. For some analysts, it determines a good price at which to buy or sell.
It’s important to note that the VWAP is a lagging indicator because it is based on historical data. Despite this, traders still use it as a way to find the true average price for a security. And because institutional traders use the VWAP as a benchmark for execution activity, the VWAP price level is considered to be highly influential in intraday price action.
Kyle Krehbiel developed the volume-weighted average price indicator in the 1980s.
Applying VWAP
There is a natural selling pressure when a stock is trying to break above or below the VWAP. When a stock or the market tries to break above or below the VWAP line or a VWAP cross, there is usually a battle between buyers and sellers. If a stock tries to break above or below the VWAP level multiple times throughout the day, traders and analysts can see that it is a good price to either buy or sell.
However, some short-term traders like to wait for one side to lose the battle and either go long on a break above the VWAP or short on a break below the VWAP. The VWAP can also help traders and analysts gain insight into where the momentum is at a specific time frame.
For example, let’s assume that a trader was short a stock because there was constant selling pressure and the stock failed to break above the VWAP multiple times. If the stock reverses and has a clean breakout above the VWAP, the trader should look to cover the short because they may be on the wrong side of the trade; the momentum has shifted to the buy side because the sellers have let up.
What Is a Technical Indicator?
A technical indicator is a calculation used by technical analysts and traders. Indicators are based on price or volume. Indicators are found by gathering and analyzing historical data by investors who use the information to determine entry and exit points, trends, and momentum in securities or markets.
Is the VWAP a Bullish or Bearish Indicator?
The VWAP is used by traders to evaluate price and volume to determine entry and exit points. It can also be used to whether there are any trends or overlying sentiments in the market. It isn’t bullish or bearish on its own. Rather, it points to a bullish trend if prices and volumes rise and bullish if they drop.
Why Is Trading Volume so Important in Technical Analysis?
Trading volume represents the total number of units of a security (like a stock) during a specific time—usually during the trading day. This measure lets investors and financial professionals know how much of a security changes hands within some time.
Technical analysts look at trading volume to help them determine whether there are entry and exit points when they trade securities—and where. That’s because trading volume helps them evaluate significant market moves. High-volume trades are relevant while those with low volumes are deemed less significant.
The Bottom Line
Technical traders use the volume-weighted average price indicator to help them find entry and exit points in the market. It also gives them insight into the prevailing market sentiment and trends. Since it uses historical data, it is a lagging indicator. Although some traders still consider the VWAP to be fairly accurate, it may be prudent to use it with other technical tools to ensure that your trading strategy is on the level.
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