Volume Weighted Average Price

The volume weighted average price (vwap) essentially presents key insights to those engaged in the activity of daily trading. It helps better understand the average price a particular asset is traded at during the day. To give this result, it considers both the volume and price. Vwap provides the ratio between the cost of that asset traded and the total quantity or volume of transactions during the trading session. 

It is a very crucial trading benchmark, plotted day-wise. It takes the opening price at the start and ends at the close price. Generally, traders compute it on a single-day basis, but one can choose any two-time points to arrive at the results—the vwap on the whole traders a picture of the performance of an asset trade during the day. 

Vwap is a versatile tool that has multiple uses. Most traders think of it as an influential tool when trading in the short term. Investors who aim to execute their trades passively often use the vwap tool. The main focus of using it is to ensure the trades executed are in line with the volume of an asset. Some people argue that such strategies reduce transaction costs by bringing down the costs of market impacts. The market impact costs may include the adverse effects of traders’ activities on the prices of an asset. The following are how Vwap is used in different ways. 

1. Many traders extensively use it for finding suitable securities to invest in. 
2. The large institutional buyers and Mutual fund portfolio managers put this into work when they want to buy a good number of shares of a particular stock. They buy or sell stocks with even minimal market impact. So always try to buy below the vwap and cell about it. Their activities take the price back towards the average rather than pushing it away.
3. Retail traders use this tool to find future investment opportunities in a stock. 
4. People involved in intraday trading try to figure out the mean price in the market to buy a stock below the vwap. They prefer to initiate long positions as the price climbs above the vwap and initiate short positions as the price slips below the vwap. 

Difference Between Volume weighted Average Price and a Simple Moving Average

Like the Vwap, a simple moving average gives a slightly stable view of the price trends of an asset. On the chart, both can also look similar. However, the two indicators provide different things. In Vwap, one calculates the sum of price multiplied by volume and then divided by the total volume. A simple moving average is something up closing prices over a fixed period and further divided by the number of periods. The quantity or volume is not a factor considered here. This difference in approach is because vwap measures the change in price by the quantity traded. However, the simple moving average considers the quantity is the same for all trading days.

VWAP= (cumulative price* volume) ÷ (cumulative volume)

Volume weighted average price considers both the cost and volume of a stock. It is not hard enough to understand that price is an important metric to consider. The difficulty may arise in understanding why and how the volume becomes essential. The answer lies in the fact that quantity or volume is an indicator of the quality of a stock. It hints at whether to buy or not—the stock with very high demand in the market and reasonably high price signs of a good stock. 

There may be cases where a particular stock has a very lucrative price. Even then, the volume of trading might be meager. Very few investors for traders are showing interest in INR in that stock. Therefore there are no buyers for it. Overall, the volume-weighted average allows readers to compare both price and demand of a stock. It is a tremendous advantage in daily trading. 

How Does One Interpret a VWAP Indicator

The vwap is a significant indicator for the traders regarding the mate of stock prices. It assists them in identifying the exact point in a period where the momentum lies—The latest taken example to understand this better. A trader may be considering a stock that failed to break out the above vwap line several times. It happened because there was constant selling. Hence he may wish to know the particular point where the stock can successfully break above the vwap indicator line. Otherwise, he would be stuck on the wrong side of market momentum. It may lead to making a wrong bet by entering a short position. The stocks which are below the VWAP line are generally of low value. Traders choose to enter into short positions for them. On the other hand, the prices above the VWAP line are high.

One can employ a technical system to determine when the price will move above the VWAP line or slide below. It should draw and combine the candlestick chart and trend lines. In the VWAP chart, a trend line is similar to a support and resistance line. The candlestick line is for the price movement of a stock. You can look at a few more terms in connection with VWAP. 

1. VWAP cross: The trading indicator works when the price of a stock crosses the VWAP line.

2. Trade fill: the executed order related to buying and selling assets. 

3. Typical price indicator: is the average stock prices presented on a line graph during a trading day. Some traders use this as a replacement for the closing price to draw a moving average prices line.

Calculation of VWAP

Vwap can differ significantly on the time frame along with price calculation. However, VWAP is mainly for one trading day and takes a 1-minute time frame. The volume weighted average price formula is as follows:

          VWAP = Σ Price * Volume/ Σ Volume

There are five steps in the calculation of VWAP.

1. The calculation starts by finding the typical price of the first completed candle on the chart. To calculate it, the formula used is [(High + Low + Close)/3)]. This price is the average of high price, low price, and the candle’s closing price.

2. The second step involves multiplying the typical price of 10 and the volume in the specified period. It will give the total price volume. The formula for this is (typical price * volume).  The VWAP for the first candle is the typical price as volume cancels out in the first input of the calculation. From the second candle, the formula calculates the cumulative price. It then continues for each successive candle. 

3. Next, keep the above process running to find the value for all the candles. The cumulative total of the typical price is represented as cumulative (typical price * volume).

4. Then, you have to get the cumulative total volume. For this, keep the vwap running throughout the total volume and price information dead during the entire day. 

5. Finally, divide the cumulative values obtained.

So, VWAP = Cumulative (Price * Volume)/ Cumulative (Volume)

Limitations of VWAP (Volume-Weighted Average Price)

Market Impact: VWAP calculations are based on the quantity of trades that were conducted over a given time frame. Executing huge deals, however, can have a major negative impact on the market and cause price distortion. The average price at which the security was traded may not be adequately represented by the VWAP in light of this.

Time Sensitivity: VWAP is a temporally dependent metric that is computed for a particular time frame, usually the trading day. The same time frame must be used for all trades if traders want to utilise VWAP as a benchmark. The VWAP computation loses significance if trades are executed outside the specified time frame.

Lack of Flexibility: VWAP is calculated using the total traded volume during a given time period. As a result, it does not take into account any changes in market conditions or shifts in supply and demand dynamics that occur after the calculation is made. This lack of flexibility can limit its effectiveness in dynamic market environments.

Limited Intraday Analysis: VWAP is primarily used as a benchmark for comparing execution prices against the average price of the day. However, it may not provide detailed insights into intraday price movements or trading patterns. Traders looking for more granular information may need to supplement VWAP analysis with other indicators or metrics.

Illiquid Securities: VWAP calculations rely on traded volume, which can be a challenge for illiquid securities with low trading volumes. In such cases, the VWAP may not accurately reflect the average price since a small number of trades can disproportionately influence the calculation.

Lack of Market Depth Information: VWAP does not provide information about the market depth or the order book. It considers only the executed trades and their respective volumes. Traders who rely solely on VWAP may miss crucial information about the presence of large orders or significant buy/sell imbalances in the market.

Limited Forecasting Ability: VWAP is a historical indicator that represents the average price at which a security was traded in the past. It does not provide predictive insights into future price movements or market trends. Traders should use VWAP in conjunction with other tools and analysis techniques to make informed trading decisions.

Impact of Extreme Trades: VWAP calculations can be disproportionately influenced by large trades, especially when they deviate significantly from the prevailing market prices. In such cases, the VWAP may not accurately reflect the overall market sentiment or the true average price.

Conclusion

VWAP is a popular benchmark and trading method, but it’s crucial to be aware of its drawbacks. The possible market impact, time sensitivity, lack of flexibility, restricted intraday analysis, difficulties with illiquid assets, lack of market depth information, restricted forecasting abilities, and effects of extreme trades should all be considered by traders. By being aware of these restrictions, traders can make better-educated trading decisions by utilising VWAP more efficiently and combining it with other indicators and research methods.