VWAP Indicator: How to Use It, Strategies and Pro Tips

The VWAP (Volume Weighted Average Price) Indicator serves as an essential instrument in your trading toolkit of technical analysis. This indicator is engineered to furnish you with valuable data on the average price of a security over a given period while incorporating trading volume into the equation. You’ll find VWAP widely employed by both individual traders like yourself and larger institutions to evaluate market conditions, make data-driven trading decisions, and effectively manage risk.

As Ananth Madhavan, Managing Director of Research of ITG in New York, stated in his study: 

“While VWAP strategies are relatively straightforward in concept, their implementation can be difficult.” 

Hence, we will give you a comprehensive guide on everything there is to know about the VWAP indicator while also giving you actionable strategies you can use immediately. We will start with the basics, continue with the strategies and finish with potential pitfalls: 

• What is the VWAP Indicator? (Comparison to Moving Averages Indicator)
• VWAP Trading Strategy Ideas (Buy and Sell Strategies) 
• The Potential Pitfalls of Using VWAP in Trading 

What is the VWAP Indicator?

VWAP, which stands for Volume Weighted Average Price, is essentially an average price. However, distinct from traditional averages that solely consider the time factor, VWAP incorporates trading volume as a pivotal component in its calculation. This inclusion endows you with a more robust measure for assessing true market sentiment and price trajectory. The formula for VWAP is relatively straightforward:

VWAP = ∑(Price * Volume) / Total Volume Traded

• Price represents the price of the security at each trade.
• Volume represents the number of shares or contracts traded at each price.
• Total Volume Traded is the sum of all trading volumes within the specified time frame.
• VWAP calculates the weighted average of prices based on the volume traded at each price level, giving more importance to trades with higher volumes.

VWAP is represented as a single line on trading charts, typically displayed as a continuous line running through the chart’s price data. In the chart below, it is represented as a blue line for easy visibility. You can use this line to assess whether current prices are above or below the average price weighted by trading volume.

The optimal settings for the VWAP (Volume Weighted Average Price) indicator can be contingent on factors like your trading approach, the asset you are trading, and your chosen time frame. We recommend using the VWAP indicator for intraday trading or swing trading:

Intraday Trading: This is the lowest timeframe you can go in trading. For short-term scalping, you may choose a “Session” timeframe ranging from 1 to 5 minutes. A “Session” timeframe of 5 to 15 minutes may be more appropriate for broader intraday trading strategies.

Swing Trading: For multi-day VWAP, you would need to adjust the VWAP period to span several “Weeks” or “Months” within the “Week” or “Month” timeframe settings.

To supplement the VWAP line, you have the option to add standard deviation bands within your selected session-based timeframe for assessing volatility. 

As the accompanying chart demonstrates, standard deviation bands—depicted in yellow—are incorporated. These bands serve multiple functions: they offer insights into price volatility, help identify support and resistance levels, confirm prevailing trends, signal conditions of being overbought or oversold, provide cues for exit and take-profit points, and aid in risk management. You have the flexibility to tailor these bands to adapt to various market conditions and strategies, enhancing their utility in your technical analysis.

Importance of VWAP in Trading

VWAP, or Volume Weighted Average Price, is crucial in your trading activities for several reasons. First, it serves as a benchmark for you, allowing you to evaluate if you are entering into positions at prices that are favourable (below VWAP) or selling at levels that are advantageous (above VWAP). VWAP also assists you in risk assessment by offering data on how much the current price deviates from the average price backed by trading volume. In fact, according to research of Jędrzej Białkowski, Serge Darolles, Gaëlle Le Fol, it is possible to reduce execution risk in VWAP (Volume Weighted Average Price) orders by modelling intraday volume. 

Additionally, VWAP supports your decision-making by delivering valuable intel on market trends. In an intraday session chart with a 15-minute timeframe, you might observe price surges above the VWAP indicator, indicating a likely bullish trend. After this, significant volume may funnel in, further elevating the price above the VWAP line in a bullish movement. Finally, the price could re-test the VWAP line and press for higher highs during the session.

Comparing VWAP to Other Indicators

Compared to other indicators like simple moving averages, VWAP has distinct features. It includes volume data in its computations, giving you a more rounded understanding of market behaviour. This separates it from moving averages that only focus on price data. In a chart, you might notice that VWAP, indicated within blue boxes, is particularly responsive to price swings accompanied by large volume. The magnitude of candle sizes in the volume chart below might directly influence how strongly the VWAP reacts, setting it apart from a lagging moving average, typically represented by a purple line.

You might also find it beneficial to use VWAP in tandem with other indicators. This dual application offers several advantages: First, it can corroborate potential trading opportunities, boosting your confidence in your trading decisions. Second, it helps you accurately pinpoint entry and exit points, especially valuable in volatile market conditions. Lastly, it supports you in risk management by helping set stop-loss and take-profit levels based on price proximity to VWAP.

In summary, the unique capacity of VWAP to integrate volume data into average price calculations renders it an indispensable tool in your trading strategy. You can count on VWAP to benchmark prices, evaluate risks, and make informed decisions for short-term or long-term trades. When employed alongside other indicators, VWAP can augment the precision and efficacy of your trading approach.

VWAP Trading Strategy Ideas

As researcher and trading expert Takashi Kato puts it in his study: 

“As an execution strategy that exploits trading volume, the volume weighted average price (VWAP) strategy is well known and widely used in practice.” 

Obviously, imagining a specific strategy without seeing it in the charts is always tricky, so we always prepare some real-world examples. We will show you two simple strategies for buying and selling according to the VWAP indicator. These strategies are aimed at beginners, and you can apply them immediately in your trading approach. 

VWAP Buying Strategy

This real-world example focuses on effectively utilizing the VWAP strategy with GameStop (GME) stock on a 5-minute chart. Although GME is chosen due to its high daily volatility, you can apply the strategy to any stock you’re trading. The scenario concentrates on going long on daily breakouts above the VWAP line.

Step 1: Identifying the Breakout – 18.10 Breakout

Initially, your task is to identify a breakout. With GME being highly volatile, daily breakouts are not uncommon. At an 18.10 price level, you can observe a breakout above a critical resistance point on the 5-minute chart. The absence of a surge in volume during this breakout doesn’t conclusively confirm bullish momentum. The VWAP line remains relatively stable, suggesting this may not be the ideal entry point. However, it’s an initial indicator of potential bullish activity, hinting that a price surge may be forthcoming.

Step 2: The Re-Test of VWAP – Wait for Better Entry

Though the initial 18.10 breakout suggests a possible entry, you, like many seasoned traders, would recognize that a re-test of the VWAP often provides a more reliable setup.

Step 3: Recognizing the Re-Test – 18.30 Entry

Post-initial breakout, the price of GME retracts toward the VWAP level (re-test). This retraction is marked by reduced volume, suggesting the waning of selling pressure. As the price nears the VWAP, it doesn’t decisively break below this level owing to insufficient selling volume. Instead, it establishes a lower high, indicating possible strength in the stock.

Step 4: The Surge Above VWAP – 18.30 to 19.40

When GME’s price subsequently ascends above the VWAP line, this time backed by significant volume, it’s a clear indicator that buying control is reasserting itself, and a sizable price movement is imminent. If you entered the trade at around 18.30 during the VWAP re-test, you would be well-positioned to capitalize on the ensuing price surge, which sees GME moving from 18.30 to 19.40 within a short time frame.

Step 5: Exiting the Trade – Price Retracement to VWAP

Upon GME hitting 19.40, you would closely scrutinize the stock’s behaviour. Noting the significant move, you understand the prudence in taking profits. As the price reverts to the VWAP level, it offers you an opportune moment to exit the trade, thus securing your gains.

This example underscores the efficacy of the VWAP strategy when trading highly volatile stocks like GME. By patiently waiting for a re-test of the VWAP following a breakout, you heighten the odds of entering a trade that aligns with the prevailing trend. The VWAP serves as a dynamic support and resistance level, aiding you in decision-making and effective risk management. The adaptability of this strategy to diverse stocks and timeframes furnishes you with a versatile tool for capturing short-term price movements.

VWAP Selling Strategy

This strategy provides a comprehensive approach to trading bearish reversals by combining the use of Heikin Ashi candles and the VWAP (Volume Weighted Average Price) indicator. Aimed at traders looking to profit from price breakdowns, this strategy is illustrated on a 5-minute chart of GameStop (GME) stock, a volatile trading instrument.

Step 1: Identifying the Breakout – 19.30 Entry

In the first step, you notice GME breaking out above a key resistance level at 19.30. This breakout is accompanied by a significant uptick in volume, and the price candles push beyond the upper yellow VWAP band.

Step 2: Confirming with Heikin Ashi – Entry Point

Before entering the trade, you consult the Heikin Ashi candles. They turn red, signalling bearish momentum. When this happens with increased selling volume, it’s a robust confirmation for initiating a short position.

Step 3: The Re-Test of VWAP – Wait and Adjust

After establishing a short position, you wait for the price to retrace to the VWAP level, a crucial area for trend continuation. During this period, you closely observe price action, ready to adjust your stop loss if you see signs of trend reversal.

Step 4: Recognizing the Re-Test – Steady at VWAP

You notice that the volume is relatively low during the retracement, suggesting sellers are losing momentum. Importantly, GME doesn’t convincingly break above the VWAP level due to lacklustre buying volume. This indicates potential weakness and reaffirms that sellers are still in control. You decide to stick with your existing short position.

Step 5: Riding the Trend – Stop Loss Adjustment

While maintaining your short position, you closely monitor GME’s performance. As the stock continues to decline, you adjust your stop loss to just above the VWAP level to manage risk effectively.

Step 6: Exiting the Trade – Price Retracement to VWAP

As you continue holding the short position, you look for signs of a potential trend reversal. Here, Heikin Ashi candles and the VWAP indicator are your guiding lights. Specifically, you watch for the Heikin Ashi candles to diminish in size and possibly change colour while also monitoring if the price is approaching the lower VWAP band, signalling a potential oversold condition.

Step 7: Exit Confirmation – Around 18.40

Finally, when GME reaches around 18.40, the Heikin Ashi candles show signs of indecision or reversal. At this point, you decide to exit the short trade, locking in your profits.

Blending Heikin Ashi candles and VWAP increases the likelihood of capturing well-timed, bearish trades. The attention to detail—waiting for the price to retest VWAP, confirming with Heikin Ashi, and continual stop-loss adjustment—ensures that the trader stays aligned with the prevailing trend while managing risk effectively. As a result, this strategy proves versatile and adaptable across various stocks and timeframes, making it a valuable approach for traders focused on bearish reversals.

Risk Management Using VWAP

The Volume Weighted Average Price (VWAP) is commonly implemented for identifying trade entry and exit points, but it also possesses utility for risk management. We usually recommend two main points to keep in mind when using the VWAP indicator for risk management:

Stop-Loss and Take-Profit Parameters: For trades positioned long, a stop-loss level below the VWAP is often implemented. Conversely, for short positions, a stop-loss above the VWAP is standard. As you saw in the previous strategy, you might also use the bands around the VWAP levels to set your stop loss and take profits.  

Re-Entry Point Assessment: When an initial trade is stopped, the VWAP can serve as a reference for re-entry. Re-engagement with the position is typically considered upon the price nearing the VWAP, aligned with confirmation from other indicators. This is similar to the previous strategy, where we entered the position once the VWAP level was retested. 

The Potential Pitfalls of Using VWAP in Trading

VWAP (Volume Weighted Average Price) is a powerful tool in a trader’s arsenal, but like any trading indicator, it comes with its own set of limitations and potential pitfalls that traders need to be aware of. In this section, we’ll explore these limitations and discuss strategies to mitigate their impact.

Late Signals

One of the primary pitfalls of using VWAP is the potential for late signals. VWAP calculations are based on historical data, which means they may not provide real-time signals. This is not such a big issue, as most of the indicators are based on historical data, but one must be aware of it. As a result, you might miss out on some early entry or exit opportunities, especially in fast-moving markets. Luckily, the VWAP is a rather responsive indicator, yet traders need to be cautious about relying solely on VWAP for immediate decision-making.

How to Mitigate Late Signals:

• Combine with Other Indicators: To address this issue, consider combining VWAP with other technical indicators that provide more timely signals. For example, you can use shorter-term moving averages or momentum oscillators to confirm VWAP signals.

• Intraday Monitoring: Continuously monitor your trade and market conditions. Be ready to adjust your strategy or exit a trade if you notice significant price movements that are not reflected in VWAP.

Market Noise

VWAP can be sensitive to market noise, especially in lower-volume stocks or during volatile trading sessions. Market noise refers to random price fluctuations that can distort the accuracy of VWAP calculations. In such cases, VWAP may not provide a clear picture of the true market sentiment. Also, refrain from using the VWAP filter right after it gets reset. For example, if your settings are set to a “Weekly” timeframe for the VWAP, then you should wait for the first hours of the week to allow the VWAP to arrive at an adequately calculated value. 

How to Minimize the Impact of Market Noise:

• Use Higher Time Frames: When dealing with noisy markets, consider using higher time frames like the 1-hour or 4-hour charts. Higher time frames can help filter out some of the short-term market noise.

• Volume Filter: Implement a volume filter alongside VWAP. Only consider VWAP signals when trading volume exceeds a certain threshold. This can help reduce the impact of noise on your trading decisions. In the chart below, you can see a volume indicator and a volume filter below the chart. The volume indicator is showing even the smallest volume; the volume filter only shows more significant volume moves. You can get both indicators simply by searching in the indicators toolbox above the chart. 

Not a Standalone Indicator

Perhaps the most critical pitfall to avoid is relying solely on VWAP as a standalone indicator. VWAP is a valuable tool, but it’s most effective when used in conjunction with other trading strategies and indicators. Depending solely on VWAP can lead to missed opportunities and increased risk.

Why VWAP Should Be Used Alongside Other Indicators:

• Confirmation: Combining VWAP with other indicators like moving averages, RSI, or MACD can provide confirmation of signals. When multiple indicators align, it strengthens the validity of a trade setup.
  
• Diversification: Relying solely on one indicator can lead to a narrow view of the market. Using a diverse set of indicators allows you to consider various aspects of price action, volume, and momentum.

How to Avoid Pitfalls

To maximize the utility of VWAP while mitigating its inherent limitations, you may find the following guidelines useful:

Educate Yourself: Acquiring a comprehensive understanding of VWAP, its applications, and its limitations positions you well for effective utilization. Knowledge remains a pivotal asset in your trading toolkit. Check our article on “How to Grow A Small Trading Account“; you may find it helpful. It offers actionable tips and insights that can be applied (regardless of whether your financial goals are big or small) to maximize your earnings and minimize risks. That guide will also take you a step further and show you how to create a winning strategy and a great trading system. 

Combine with Other Indicators: Utilizing VWAP in isolation can expose you to unnecessary risks and missed opportunities. Therefore, it’s prudent to use VWAP alongside other technical indicators for a more robust signal confirmation process. Read our feature on “Technical Analysis Using Multiple Timeframes” to get more ideas on how to implement other indicators and charting techniques. 

Adapt to Market Conditions: Understanding that VWAP’s efficacy can fluctuate based on market volatility and liquidity conditions enables you to modify your strategies as needed. This adaptability could prove crucial in maintaining a consistent performance. As for further reading on this matter, you might want to understand how market cycles work in general. To gain a deeper understanding of these dynamics, check out our guide on “Market Cycles” which shows you how to stay ahead of the game. 

Conclusion

That was everything you need to know about the VWAP indicator to get you started. Remember to start small and try things out before trading with a large amount of money. Decide on your strategy, whether it is short or longer timeframes, test things out and gradually build your confidence and experience. Combining VWAP with complementary indicators tailored to your trading style will be your secret weapon. Smart risk management is key to safeguarding your capital, so use VWAP to set stop-loss and take-profit points.

But the journey doesn’t end here; it’s a continuous learning process. Adapt your strategies as market conditions change, and exercise patience by waiting for clear signals. Remember, sometimes not trading is the best trade. Don’t hesitate to apply the buy and sell strategies we’ve provided, as they can be implemented right away. Moreover, keep honing your skills with the guides we’ve shared, as staying updated with market trends is crucial. With practice and determination, you’re well on your way to unlocking VWAP’s full potential and making profitable trades. 

Disclaimer: All investments involve risk, and the past performance of a security, industry, sector, market, financial product, trading strategy, or individual’s trading does not guarantee future results or returns. Investors are fully responsible for any investment decisions they make. Such decisions should be based solely on an evaluation of their financial circumstances, investment objectives, risk tolerance, and liquidity needs. This post does not constitute investment advice.