The VWAP is arguably one of the most powerful indicators available to day traders. Knowing how to effectively use the VWAP will make all the difference in your trading strategy. In this article, we will go over the basic concept, how to enhance it with standard deviation bands, and when to apply this strategy for optimal results.
What is VWAP?
VWAP is the abbreviation for Volume Weighted Average Price. Because the calculation depends on both price and volume, hence giving traders an average price of an asset over some period, usually a day of trading. The VWAP line shows the mean value upon which the security has changed hands throughout the day.
Why VWAP?
Institutions rely a great deal on VWAP because it enables them to make large trades without necessarily moving the price of the market. In the case of retail traders, VWAP can be used to decipher the overall market sentiment. The common interpretation is:
- Price above VWAP: overbought asset.
- Price below VWAP: The asset is cheap.
The VWAP Trading Advanced Techniques for Better Trading
Enhancing VWAP with Standard Deviation Bands
Although VWAP itself gives insightful information, the addition of standard deviation bands shows when an asset is seriously deviating from its average price. Here’s how it works:
- Upper and Lower Bands: These are plotted two standard deviations above and below the VWAP line. The upper band shows overbought, while the lower band shows an oversold condition.
Strategy
- This would include buying when prices are below the lower band because they have reached an undervalued state, and then selling when the prices are at the upper band as this means an overvaluation. However, it gives a signal for selling when the price reverting back towards the VWAP.
The Secret Sauce: When Not to Trade VWAP
First 30-45 Minutes
It’s always better to avoid trading at the opening of a market. The volatility is really high, and VWAP cannot be relied upon. In this initial 30-45 minute timeframe, prices drastically change without any direction. Thus, it is prudent to wait for the stabilization of the market before considering a trade on VWAP.
Understanding Market Conditions
VWAP works best in range-bound or sideways markets, not in trending markets. During a strong trend, one should switch to a trend-following strategy rather than using the VWAP for mean reversion.
Using VWAP with a Timing Indicator
While VWAP helps identify when an asset is overextended, it does not provide the exact entry points. That is where a timing indicator comes in: it fills in the details needed to provide you with exact entry and exit points so that you can enter trades with confidence.
Complementary Strategy
The VWAP picks up statistical extremes, while the timing indicator refines your entry and exit to make trading more precise.
How to Use VWAP Effectively
Don’t Chase the Price
Allow price action to come to the VWAP standard deviation bands. Enter when the price starts reverting toward VWAP, not when it’s far from it.
Be Patient
VWAP trading does not provide too high a frequency of signals. One needs to wait for appropriate conditions.
Timing is Everything
Only use VWAP when the market has defined its bias, well after the first 30 to 45 minutes of trading activity.
Conclusion
The VWAP is a powerful tool for a day trader interested in what is the average price that the market has moved through, and potentially reversing around. Adding on standard deviation bands allows it to layer in an amount of specificity so now you can trade with statistical probability. The key to this, like I said earlier, is actually using the VWAP with some type of timing indicator that’ll give you your exact entry and exit.
Want to be a master in VWAP trading? For a free webinar on how to incorporate the timing indicator into your trading strategy, go to indicatorwebinar.com.
