Volume-Weighted Average Price (VWAP)
Volume-Weighted Average Price (VWAP) is a trading benchmark used by investors especially in pension plans and in some mutual funds. It is calculated by adding up the amount of money traded for every transaction, i.e., the price multiplied by number of shares traded, and then dividing the figure by the total shares traded over a particular period, which is usually a single day.
Theory behind VWAP:
Investors, who use this benchmark, go by the theory that if the price of a buy transaction is lower than the VWAP, it is a favorable transaction, while the opposite holds true if the price is more than the VWAP. Investors who intend to show themselves as passive as possible in their transactions use this trading benchmark. The objective of using VWAP is to ensure that an investor executes his order in compliance with volume on the market.
Guaranteed VWAP execution:
Though VWAP can be measured between any two points in time, it is always displayed as parallel to elapsed time during the trading day by the information provider.
A broker could also guarantee an order's execution at the VWAP price and use a computer program to enter the orders into the market so that he earns the trader's commission and create profit and loss. This is called a Guaranteed VWAP execution.
Tick versus minute:
Traditional VWAP is based on tick (trade) data. This is in reference to the many ticks (trades) during each minute of the trading day. Active securities during periods of active trading can have 20-30 ticks per minute. Hence, as most stock exchanges trade for about 390 minutes in a trading day, many stocks can gather well over 5000 ticks per day. If there are more than 5000 stocks traded every day, such ticks get added up exponentially. This makes tick-data very resource intensive.
VWAP is calculated using five steps. Firstly, the typical price for the intraday period needs to be computed. This is the average of the high, low and closing prices of a stock.
Secondly, this computed price has to be multiplied by the trading period's volume. Then, one needs to create a running or cumulative total of these values. Similarly, a cumulative total of volume has to be created next. Finally, the running total of price-volume has to be divided by the running total of volume.
VWAP does not keep pace with stock prices as it is an average based on past data, and the more the accumulation of data, the greater the difference in price and VWAP. A stock, for instance, has been trading for about 331 minutes by 3 pm --- the time of closing of the stock market. As a cumulative 'average', this indicator is similar to a 330 period moving average. This is a significant amount of past data.
The 1-minute VWAP value at the end of the day is usually closer to the ending value for a 390-minute moving average. Both the moving averages are based on the 1 minute bars for that day and at the day's close, both are based on 390 minutes or one full day's data.
However, the 390-minute moving average cannot be compared to VWAP during the day because a 390- minute moving average at noon will include the previous day's data, while VWAP will not.
All VWAP calculations begin anew in the opening of share market and end at the close of trade. As 150 minutes of trading is assumed to get over by noon, VWAP at this period would require comparison with a 150-minute moving average.
In spite of the difference, chartists can compare VWAP with the current price to determine the overall direction in which intraday prices will head. Similar to moving averages, intraday prices generally fall when they are below VWAP and rises when above VWAP.
Uses of VWAP:
VWAP is often used in automated or algorithmic trading, where computer programs are used for entering trading orders with the computer algorithm deciding on various aspects of the order, which include the timing, price, order quantity, or, as done mostly, initiating the order without human intervention.
VWAP is also used to identify liquidity points because being a volume-weighted price measure it reflects price levels weighted by volume. Institutional investors with large orders can benefit from this. The basic motive is not to disrupt the market when entering large buy or sell orders. VWAP helps large institutional investors determine the liquid and illiquid price points for a specific security over a very short time zone.
VWAP can further be used to measure trading efficiency. Institutions and individuals can compare their price to VWAP values after buying or selling a security.
A buy order executed below the VWAP value would be considered a good trade because the security has been bought at a price below average. Conversely, a sell order executed above the VWAP would be seen as a good trade because it has been sold at a price above average.
VWAP can be plotted as an 'overlay' indicator on SharpCharts. For this, one needs to enter the security symbol and choose an 'intraday' period and a 'range'. This can be for a single day or for 'filling the chart'. Chartists who want to get more details can choose the latter while those wanting to see general levels can choose the former.
VWAP can also be plotted for more than one day, but the indicator will jump from the value it had earlier closed to the particular price for the following opening day because a new calculation period begins.
Furthermore, VWAP values can sometimes fall off the price chart. VWAP at 55.5 can show up on a chart with a price range 55.8 to 57. This factor sometimes prompts chartists to extend the range to a full day to see VWAP on the chart.
VWAP serves as a reference point for prices for one trading day. This makes it most suitable for intraday analysis. Chartists can compare current prices with the VWAP values to determine the intraday trend. VWAP can also be used to determine relative value.
Prices below VWAP values are relatively low for the particular day or time horizon in question, while prices above VWAP values are relatively high for that same period.
It must be remembered that VWAP is a cumulative indicator, which means the volume of data points keeps on increasing throughout the day. For instance, on a 1-minute chart, global technology and consulting firm, IBM, can have 90 data points (minutes) by 11 am, 210 data points by 1 pm, and 390 data points by the end of trade.
The volume increases significantly as the day progresses. This is the reason why VWAP cannot keep pace with stock prices and this lag extends as the day progresses.