According to Wikipedia's definition, In finance, volume-weighted average price (VWAP) is the ratio of the value traded to total volume traded over a particular time horizon (usually one day). It is a measure of the average price a financial instrument such as stock or futures traded at over the trading horizon.
Why is important
With VWAP benchmarks, a trader or an algorithm models the volume distribution and then slices and dices the trades within a certain time interval on that distribution. As long as an algorithm does that, it is likely to achieve the VWAP over a given time horizon. This is true even if there are significant stock price moves during the day, either due to market impacts of the trading or due to the stock’s volatility.
Broker-dealers favor VWAP as a benchmark. Again, because VWAP is an uncomplicated benchmark, most VWAP trading strategies are simple and relatively quick to execute. All broker-dealers now possess some form of algorithms run on computers to assist them or to trade automatically.
The most professional brokerage firms offer what is known as Guaranteed VWAP execution to large institutional clients. Guaranteed VWAP is the process of executing trades exactly at the VWAP price.
The second option offered by brokers is VWAP target execution where the broker makes a best effort to execute near the VWAP without guarantees. Target execution incurs more dispersion in the answered price compared to the VWAP price for the client, but a lower received/paid commission. Trading algorithms that use VWAP as a target belong to a class of algorithms known as volume participation algorithms.
VWAP is used to identify liquidity points.
As a volume-weighted price measure, VWAP reflects price levels weighted by volume. This can help institutions with large orders. The idea is not to disrupt the market when entering large buy or sell orders. VWAP helps these institutions determine the liquid and iliquid price points for a specific security over a very short time period.
The VWAP is a great tool to spot the action of Very Active money Pools.
Once I have established a bias, either long or short bias, have my hypothesis in place, inflection points established and my goals in mind, I monitor the VWAP for timing when approaching my pre-established areas of interest.
I use the indicator as a compass or support tool. If I have a long bias, prices are near an area of interest and it is trading above the VWAP with a bullish tone, I take the trade. The most important variables like order books incoming volume, positive delta, ATR are supporting my hypothesis and the VWAP helps to confirm my long bias.
As mentioned in earlier post I am using indicators from lizardindicators.com. Their professional VWAP collection allows to measure a market on monthly, weekly and daily VWAP basis. Lizardtraders VWAP includes some important features like
- colored VWAP line
- Standard Deviation bands (SD Bands)
- CME Holiday Calendar
- lot more customizable features
With the help of SD Bands I am alterted that a price is in a zone where a correction is likely to happen.
The Reason why VWAP became such an important tool in trading today relates to one factor: Simplicity! VWAP’s enduring appeal lies in its ease of calculation, understanding, implementation and attainability and it is a non-lagging indicator.
I would appreciate your comments to VWAP and it's use in your trading environment.