Stock charts are good for telling the story of a price over a given time period. But they can also create a lot of noise and potentially make it hard to identify the most important prices.
That’s why people use VWAP, or volume weighted average price, to find the price at which all the action took place.
Despite its intimidating name, VWAP is surprisingly intuitive. In a nutshell, VWA is simply the average trading price for a stock on a given day. This is the formula for VWAP:
Total dollar price of all the shares traded in a given day
Total volume for that day
Technical traders know that volume is a true measure of market action. Any stock can make huge moves on an odd lot or low volume, but sustained price action requires more liquidity. VWAP ties a stock’s price to its volume, painting a clearer picture of the prices at which the majority of the buying and selling has been taking place.
For example, if a stock opens at the low of the day with a 20-share trade at $8, and then closes at the high a 10-share trade at $11, a candle for that day will show a black or green bar spanning from $8 to $11.
However, that doesn’t really tell the whole story of the day. Let’s say that there were a bunch of trades that happened at the $9 level. While the trading technically ranged from $8 to $11 that day, the vast majority of the action took place at $9, the VWAP will be representative of that and show $9 as the best representation of the stock’s true price for that given day.
Traders use VWAP for a number of different strategies. One simple day-trading strategy is to buy when a stock’s price crosses above a stock’s 5-minute VWAP, using the previous period’s VWAP as a stop. This type of crossover can be an indication that buyers are stepping in.
Some traders simply use VWAP to time their short-term entry and exit points. When a stock is trading above its VWAP, it’s generally seen as a good relative price at which to sell. This strategy assumes that a stock’s “true” price is its VWAP. In the example above, the trader who bought at $8 got a good deal relative to the $9 VWAP, and the trader that sold at $11 also got a good deal.
Traders also use a mean-reversion type trading strategy centered on VWAP. This mean-reversion strategy assumes that a stock’s share price will generally tend to come back to its VWAP over time. When a stock’s share price gets too far above its VWAP, mean-reversion traders sell. When share price gets too far below, they buy.
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