When it comes to day trading, finding the average price especially on a closing value of a security will not provide you with the accurate picture of the asset’s health unless Volume Weighted Average Price (VWAP) is used.
For those who are not familiar with VWAP, it refers to the true average price of a stock where the volume of transactions is factored in at a specific price point without basing it on the closing price. VWAP trading strategies date back to the 1990s when the stock market was hot and foreign investors were eager to invest in US equities.
What you need to know is that VWAP is similar to moving average – when the price is high, it is above VWAP and when the price is below, it’s below VWAP. Just like moving average, VWAP experiences lag which is inherent in the indicator. This is because it refers to the calculation of an average using past data.
This is why its best used during intraday periods. For example if you have been using a 2 minute chart after 6 hours of trading, VWAP will have been calculated for more than 300 periods.
Here are 3 reasons why VWAP is a favorite tool for day traders.
An Important Indicator For Market Sentiment
Long term investors or day traders trading penny stocks use Volume Weighted Average Price (VWAP) to base their calculations off every tick of data in any particular trading day. It is true that every closed transaction is recorded and most charting websites prefer one minute or five minute trading prices. This is done to cut down on the sheer volume of data needed to keep track of VWAP.
For example a 5 minute VWAP calculation will require you to take the low, high and the closing price. This will be divided into three giving you the weighted average which is a fairly accurate value. The value can be multiplied by the number and volume traded within the same period finally achieving the weighted price.
As an important indicator, when the price is above VWAP, the trend can be said to be bullish and when the price is below VWAP, it is bearish. A bullish market is characterized by the increase in buying price and the trend on the chart is seen as moving upwards.
Meanwhile in a bearish market, it is characterized by increased selling pressure and the trend is charted as moving downwards. This is how VWAP scores as an important indicator for market sentiment.
Use Volume Weighted Average Price For Excellent Risk/Reward
On a fast and sophisticated level, day traders are tasked with achieving a favorable dollar cost average. When a trade execution is contrasted with the asset’s true average price, the trader’s performance is gauged objectively.
This is not enough; a consistent measurement of distance to the VWAP is needed. The most logical metric is standard deviation. It is a statistically valid method of gauging distance from the mean in this case the VWAP distance from the price.
Day traders who utilize VWAP as a technical analysis tool do not place orders as soon as the system generates a trade signal. Experienced day traders wait for a favorable price. If a stock is trading way below the VWAP indicator and you end up buying it at market price then you will not be paying more than the stock’s average price.
By using VWAP, you will be able to buy low having better rewards when you sell. VWAP helps day traders to make informed decisions finally experiencing excellent rewards.
Provides More Value Than Standard Moving Average
As said earlier, VWAP is a trading tool calculated by taking the number of shares bought multiplied by the share price. This value is then divided by the total shares bought within a particular day. It is displayed on the day trading chart as a moving average. The problem is the value is much slower than your 8 to 20 day moving average.
VWAP is not only regarded as a technical analysis tool, it’s also a key indicator and guideline for trading institutions and pension plans looking to occupy larger portions. Furthermore, it’s used to help them get a good price and into different positions without disrupting the market or increasing prices with large orders.
When it comes to day trading, timing is everything. This is the same with VWAP. Since stocks trade above, below and at the VWAP, as a trader you need to enter when stocks are making a pivotal decision. In order to achieve this, you have to scan for the set ups in real time.
Doing this will not only counter trend trading opportunities but it will reduce market impact. When this happens, it will simplify your decision making process. This is why VWAP is better than the standard moving average.
Final Thoughts
When VWAP is applied in your day trading, it will be like any other indicator but its benefits are great. Using VWAP with price action or other trading strategies simplifies your decision making strategies. What you need to remember is that VWAP will not work out everything for you. Sound trading decisions need to be made based on the market trends.
