Perhaps, one of the critical challenges that traders face is the moment of entering or leaving a trade. When they do not clearly understand market trends, many of them end up making poor decisions, which result in high losses. Even an experienced trader often falls into the traps of buying or selling during wrong times because of hazy fluctuations and volatility at times.
The Volume Weighted Average Price is a crucial tool similar to simple moving averages on which professional traders rely heavily as institutional investors but will account for both price and volume, hence providing the correct image of market momentum. VWAP is not a line drawn on a chart; rather, it is a key indicator that shows the distribution of trades at various price levels.
With VWAP in your strategy, you will make better decisions, avoid the traps of choppy markets, and even gain from extreme market movements. In this article, we will break down how one can combine VWAP with standard deviation bands to catch significant reversals for maximum profits in day trading.
What is VWAP?
VWAP stands for Volume Weighted Average Price. The calculation gives a measure of the average price at which a security has traded during the day, weighted by volume. Another way to put it, VWAP is a tool to help traders determine if the price has traded above or below the average price based on the number of shares or contracts traded.
VWAP starts fresh every day at market open and records a price for a given volume. As trades continue to take place, the line will rise or fall which very aptly informs you where most of the trades are taking place and if buyers or sellers are the trend leaders.
VWAP Power in Day Trading
VWAP is of great use to day traders as it resets every day and changes with the unfolding of the trading day. In contrast to most moving averages, which are lagging, VWAP reflects current market conditions.
Why VWAP Matters for Traders
Institutional Influence:
Institutional traders widely use VWAP because they usually have orders for a large quantity of shares to be executed and desire to execute them near the VWAP in order to get a fair price for their customers. By following the trajectory of the VWAP line, small traders can hitchhike on institutional money.
Price Fairness:
When the price is greater than VWAP, then the security is considered overbought, which means buying at a premium compared to the average volume of the day. If the price is lower than the VWAP, it is considered oversold, which is an opportunity that a trader can consider some time for a purchase.
Bollinger Bands or Two Standard Deviation Bands – The Secret Sauce
Now, here’s where the “insane profits” come in. While most traders will just use VWAP to understand what the current price is in relation to that day’s volume-weighted average, there’s a much more advanced technique in which two standard deviation bands are used.
These bands indicate extreme moves in the market, therefore, being a potential reversal signal. Standard deviation bands are plotted two levels above and below the VWAP. This creates the upper and lower boundaries. These boundaries show how far the price has deviated from the VWAP.
How to Use It:
Upper Band for Selling:
- When the price is two standard deviations above the VWAP, that can be quite often a sign of overbuying. This situation might be used for selling purposes or even introducing a short position based on the premise that the price would revert to the VWAP.
Lower Band for Buying:
- When the price drops two standard deviations below the VWAP, it is absolutely oversold, which would be a good buying opportunity since the stock or asset is likely to return to VWAP, allowing for a good trade.
These deviation bands will help you avoid false breakouts or breakdowns as you wait for the market to give you more precise entry points. This is very useful in day trading when precision is critical.
Avoid Choppy Markets With VWAP
VWAP is one of the best features that helps traders stay out of dangerous choppy markets. If it is acting around the price without a clear trend, then you should stay out, as there is no statistical edge during these periods, and you’d be trading purely based on speculation. Choppy conditions might suck your account dry if you are not careful, and VWAP will act as your defense mechanism against this.
Recognition between Trending Markets vs. Choppy Markets
VWAP can be further used to distinguish between trending and choppy markets.
In a Trending Market:
The price shows an overall upward or downward movement compared with VWAP, meaning the market has a very strong bullish or bearish trend. Here, a mean reversion based on VWAP would not be preferred; instead, a trend-following strategy would have more relevance.
In a Choppy Market:
This really tells you that there is no direction in the market when the price slices on either side of the VWAP several times. It’s there that VWAP says do not trade so much.
Understanding What Type of Market You Are In
You will also be able to change strategies on-the-fly and avoid costly mistakes knowing which type of market you are in.
Timing with VWAP
VWAP is best used after the first half an hour of the trading session. The market being too volatile in the early part of the day, the VWAP line hasn’t stabilized enough to make meaningful representation yet. It is wise to wait for the market to find direction before entering the market.
Once the noise has dissipated, you can then use VWAP and the standard deviation bands to pick good entry and exit points. Remember that if the market is moving erratically within the first half-hour, wait out till when clearer trends develop.
Conclusion
VWAP is one of the most valuable tools to trade on, in particular when combined with standard deviation bands. It helps in identifying overbought conditions and oversold conditions and brings you out of the choppy markets that do not maintain any trend. Moreover, knowing when to use VWAP and when to switch to a trend-following strategy will certainly make sure that you produce constant profits.
Whether a new trader or an experienced one, the application of VWAP in your day trading will be the difference between mediocre results and a much better outcome. In mastering the use of VWAP, one will be on their way to making insane profits in the stock market.
