The Volume Weighted Average Price, or VWAP, is a technical indicator used by traders to identify support and resistance levels, manage trade entry / exit, determine market direction, measure trend strength, and much more.
How is VWAP calculated?
Price and volume are the cornerstones of order flow data – price is the end result of buying and selling volume. The price movement depends on whether the buyer or seller was more aggressive during a trading session. The importance of a price movement often correlates with the amount of volume traded during the promotion.
The volume-weighted average price is similar to a moving average, but uses volume data to “weigh” the average price over a period of time. The basic formula used is:
In other words, VWAP takes the total dollar amount traded and divides that number by the total number of units traded.
VWAP standard deviation bands
In addition to the VWAP itself, which is shown as a single line, standard deviation lines are often used to indicate potential support and resistance, as well as other important price levels. Also based on mathematical calculations, commonly used multipliers 1, 2 and 3 are used for VWAP standard deviations.
The graphic above shows one day of Micro E-Mini Dow Futures trading over a 15 minute period. The VWAP line alternates between green and red when the price is above or below the VWAP. 3 standard deviation bands can be seen above and below the VWAP line. As you can see, the price tends to react when it comes in contact with the VWAP.
Why do dealers use VWAP?
In comparison to a traditional moving average, VWAP determines a “true” average price by taking into account the transaction volume at each price level. There are several reasons why order flow traders include VWAP in their analytical approach:
- Determination of support and resistance levels
- Tracking price reversals
- Confirm or reject trends
- Determine the strength of a market
- Fine-tune trade in and out
In addition to the uses above, Order Flow traders refer to VWAP for an idea of where institutional traders initiate and liquidate positions. VWAP is commonly used by institutions such as hedge funds and pension funds to help create and close positions. Institutional VWAP dealers are considered the benchmark for order fulfillment and seek to buy below the VWAP line and sell above it.
As with other indicators, VWAP can generate false signals and should be used in combination with other analytical tools to confirm a trading thesis. As always, risk management should be paramount to investors.
Get started with Order Flow +
VWAP is included in NinjaTrader’s Order Flow + Suite of world-class technical analysis tools. It has adjustable standard deviation bands and can be used on daily, weekly, and monthly periods.
Current NinjaTrader users can get started with Volume Profile and the rest of the Order Flow + Suite today: Learn more
New to NinjaTrader? Our award winning trading software is always FREE to use for advanced charting, backtesting and trading simulations. Get started with our free trading platform today!