The VWAP indicator (Volume Weighted Average Price)

©Trading Research - www.trading-research.com - marzo 2015 - Author: Dr.Roberto Ambrogi
Those who already know us are aware of the fact that at Trading Research we don't use price based indicators, we don't believe in the manipulation of data that are already self explanatory, because it is unnecessary and sometimes even misleading.
We do however some kind of exceptions for some indicators that, even if not so crucial for our trading decisions, are well worthy to be considered and observed, one of these is the VWAP indicator.
The VWAP (Volume Weighted Average Price) as the name implies is simply a volume weighted average of the last traded price.


The formula to be considered is the one commonly used by charting package softwares which calculates the VWAP tick by tick on the last traded price:


Formula VWAP

where:
Pj = the last traded price at time j
Qj = the corresponding traded quantity at that price (volume) 
j = time units (each variation of the last price)

The indicator will calculate in real time the VWAP value making the ratio between the cumulative amount of price x traded quantity and the cumulative volume, everything up to that point.
Usually are highlighted also two standard deviations of price compared to the VWAP above and below it as you can see from the charts below. The standard deviation formula is this:

Formula SD VWAP

VWAP range

The first higher band is continuously calculated as VWAP + σ and the first lower band as VWAP-σ; the second band will be VWAP + 2σ and the second lower band will be VWAP - 2σ; in the calculation of the standard deviation bands it is also possible to use fractions of σ but the unit is the most commonly used.
Beyond the mathematical calculations let's see the features:
1)the VWAP calculation starts from zero at the beginning of the day
2)the VWAP is a cumulative indicator so as the trading day develops the VWAP becomes increasingly insensitive to the latest changes in price and volume, (unless they are really big)
3)even if VWAP has the typical moving averages limitations (ie cannot be used alone because always lagging) it is definitely much better because it doesn't consider only the price, it weights it with the volume therefore it acquires a very different meaning, definitely much more interesting and useful.
4) Being the VWAP a volume weighted average price that starts from the beginning of the trading day, at each point the volume traded above it and the volume traded below it is identical.
5)its setting is univocal (beside some hypothetical particular settings for the bands) and it is not influenced in any way by the chart time frame, so everyone looks at the same thing, this is very different from the moving averages that can have millions of settings, (chart time frame, number of periods included in the calculation, various formulas etc..) therefore losing most of its practical utility.
INSTITUTIONAL INVESTORS USE
Institutional desks, (made by traders who have to fill big orders for institutional investors as hedge fund, mutual fund, pension fund, investment-banks etc..) are constantly judged on their ability to execute orders at the best possible price available, in this regard the VWAP is used as a benchmark to judge the quality of their executions:
For example if a desk receives an order to buy during the day a few thousand contracts of a particular instrument, this obviously cannot be done all at once, it would have a direct negative effect on prices pushing them higher and therefore worsening the average price of the whole purchase; the institutional trader will try to diluite his buying during the day by placing buy orders at levels that he believes good, and basically knowing that the VWAP will be the benchmark on which he/she will be judged.
HOW WE USE ITVWAP trend
1)because institutional take into account the VWAP for the above reasons, very often at its level and its standard deviations levels, especially if in conjunction with other important areas, something happens, that's why it is good to be aware of it
2)it's an additional input to identify the market situation of balance or unbalance, to decide whether our trading modality is set on "reversion to the mean trades" or "go with" trades; this can be done by comparing the location of the VWAP compared to the VPOC (Volume Point of Control) if they are very close it is a further confirmation of a balance situation, if, on the other hand the VWAP is very steep (upward or downwar) and precedes the VPOC there is a good probability that value will move in this direction therefore we will be looking for "go with trades".
3)taking into account all the above, if we have an entry point that coincides with the VWAP or one of its standard deviation bands, depending on the situation, this will definitely add some odds in our favor to our trading idea.
In conclusion we can say that the VWAP alone is not sufficient to identify accurate and high probability entry points, however if it is put into a context, with a proper analysis of price action, market/volume profile and order flow, it can certainly represent a valuable support to our trading decisions.
Good trading