Here we explain what VWAP is, the psychological and technical significance of VWAP while analyzing a chart, and we finish by taking a look at a specific VWAP strategy for day traders.
What is VWAP?
VWAP is defined as Volume Weighted Average Price. It does exactly as the name says in that it is a measurement that shows average price adjusted for volume. VWAP is calculated as a total of the dollars traded for every transaction, divided by the total number of shares traded.
The formula to calculate VWAP is therefore: Cumulative Typical Price x Volume divided by Cumulative Volume.
VWAP is presented as a single line on a chart that resets at the start of every trading day.
This line is referred to as an indicator.
The Psychological Significance of VWAP
Of all the indicators used by day traders, VWAP is probably the most popular. This in itself, before even considering the technical implications, confirms its importance. The fact that it is a trendy line on a chart that practically everyone refers to in some way, means that it needs to be taken seriously. Day traders who like to go short will often view VWAP as resistance to short into. Likewise, day traders who like to go long will often view VWAP as support. Because of this, both long and short traders will often have their stops either just above or just below VWAP. This in turn means that if market makers or hedge funds are controlling a particular stock and are struggling for organic liquidity, they can go stop hunting either side of VWAP in an attempt to suck in organic liquidity to either dump into, or perhaps to initiate a short squeeze that they can dump into higher up the chart.
These psychological aspects are often part of the reason why we often see explosive moves in both directions around VWAP. Day traders and institutions alike hover around the hive of activity that is the VWAP indicator, thus increasing its popularity and continued significance.
The Technical Significance of VWAP
A broad reference often thrown around by day traders is that above VWAP is good for longs and below VWAP is good for shorts. This is a simple theory that in fact holds plenty of weight. Seeing as VWAP is volume weighted average price, it stands to reason that above VWAP confirms that thus far in a trading day, long traders have had most control. Similarly, the opposite of this usually holds through when price hovers below the volume weighted average price.
However, a more precise noting of the distance from VWAP can help day traders to better utilize this indicator. For example, a stock that is 40% above VWAP is clearly overextended and any long trader looking to get involved at that point is chasing. Similarly, a stock 40% below VWAP is likely oversold and as likely to favor longs as shorts.
So, what then is the sweet spot when determining the ideal proximity to VWAP for entering a trade? Obviously there is no definite answer to this question as every situation is different. Below we delve a bit deeper into the specifics of a long strategy that uses distance from VWAP and price action around VWAP to pinpoint trading opportunities.
VWAP Strategy for Long Traders
For the purpose of explaining this strategy I will use the example of the NASDAQ stock $APLD from after hours action on Monday, July 18th to intraday action on Wednesday, July 20th.
ZeroPro, August 5, 2022)
As can be seen from the chart above, $APLD made an explosive move after hours on Monday, July 18th. The stock moved from 1.08 to 1.56 for a 43% move. It is worth noting that once it made the move it never dipped below VWAP in this after hours action. From premarket open at 4AM EST on Tuesday the 19th, right up until 12:10PM EST, $APLD chopped around both above and below VWAP. Crucially, it never dipped more than 7% below. From 12.10PM onwards it never again dipped below VWAP. However, it also never went more than 17% above VWAP. In fact, from 12.10PM to 3PM it hovered in a tight 17% range above VWAP. It is also crucial to note that by 3PM the stock had already traded over 100 million shares in volume, which was over 10x the average 10 day volume for the previous 10 days.
The core of this strategy is thus to look for stocks with abnormal volume that hover around VWAP for an extended period, neither too far above or too far below. Taking a long position just because a stock has high volume and is above VWAP is too primitive. It needs to prove that it can hold above VWAP. High volume means a lot of day traders are both long and short. It is important to see who is winning the battle before the potential explosive move happens.
Yet this info is still not enough. The price action needs to give a proper entry to indicate in which direction the explosive move is likely to happen. Repeat, being above VWAP for an extended period on high volume is absolutely not enough. Proper bullish structure must confirm itself to warrant an entry. As seen on the chart, $APLD forms an ascending triangle just above VWAP. The 5 minute candle that closes into 3PM does 3 important things that warrant the entry:
- It engulfs the previous candle.
- It clears the range from the previous hour (also the psychological level of 1.70)
- It closes strong.
At the time of entry the stock is up almost 60% from the previous day’s close, yet it is only 8% above VWAP after hovering around VWAP from 5PM on Monday to 3PM on Tuesday. During this period the overall range is 38% from 1.30 to 1.80. However, in relation to VWAP, the range is tighter at 24% due to a max of 7% below & 17% above. The stock proved that it could hold around VWAP on high volume for an extended period, with longs winning the battle and accumulating shares before the entry signals confirm high probability of an explosive move north.
It is also important that the triangle is ascending in structure, not symmetrical and not descending. This means that the bottom angle must be steeper than the top angle. Both descending and symmetrical triangles also give good long plays, but this strategy needs confirmation of a clean ascending triangle. Clean means no lines through wicks. It is also best if this intraday triangle covers a time period of at least 1 hour. The longer the hover the more accumulation for the explosion.
$APLD went on to make a 53% move from entry at 1.72 to an after hours high of 2.64.
As shown below, $APLD also met the same criteria the very next day to give another entry on Wednesday, July 20th. However, this was on the 1 minute chart, so the ascending triangle only covered a 15 minute time frame meaning less accumulation, resulting in a smaller move that gave 15% in 15 minutes from 9.52AM to 10.07AM.
(ZeroPro, August 5, 2022)
Summary
VWAP or volume weighted average price, is a popular indicator used by day traders. It presents as a line on the chart and measures average price adjusted for volume. Due to both the psychological and technical significance of VWAP, it is often a zone of explosivity from which stocks can make huge moves in either direction. Stocks that hover around VWAP for an extended period on abnormal volume, can sometimes be good long trades provided they give a proper entry.
References
August 5, 2022 - Volume-Weighted Average Price (VWAP) By JASON FERNANDO Updated May 05, 2022 Reviewed by SOMER ANDERSON Fact checked by SKYLAR CLARINE
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