Where’s the Momentum? Put VWAP to the Test

Just as an aircraft needs thrust to pick up speed and take off, so do stocks. Stocks need momentum or liquidity to pump them up and drive them to move. And traders, especially short-term ones, can potentially benefit from trading stocks with momentum. But how do you find that momentum? Be prepared to spend time observing price action—know when to pay attention and when to take a break.   

It’s a no-brainer: Volume drives momentum, which is why most chartists keep an eye on volume regardless of what indicator they’re using. Some prefer to add subcharts of volume-based indicators such as accumulation/distribution or on-balance volume (OBV). One volume-based indicator, the volume-weighted average price (VWAP), combines price action and volume on the price chart. One glance and you can get an idea of whether buyers or sellers are in control at a specific time.  

Another value-added feature of VWAP is it’s calculated from the time the market opens to when it closes. In other words, you get to see price and volume action unfold in real time during a specific time in the trading day. This can be valuable information for short-term traders.

What Is Volume-Weighted Average Price (VWAP)?

VWAP is the average price of a stock weighted by volume. What does that really mean? By monitoring VWAP, you might get an idea where liquidity is and the price buyers and sellers are agreeing to be fair at a specific time. The VWAP indicator is often used by day traders to figure out intraday price movement. Institutions and algorithms use it to figure out the average price of large orders.

How Is VWAP Calculated?

The formula is simple in that it’s a cumulative total of the price of each trade, multiplied by the volume of that trade, divided by total volume traded for the day. 

But you don’t necessarily need to know the formula. You can plot the indicator on thinkorswim charts. From the Charts tab, add symbol, and bring up an intraday chart (see figure 1). Select Studies, and from the drop-down menu, select Add Study > Market Strength Studies > VWAP.

The VWAP is displayed as a line, similar to a moving average. On the chart, it’s the purple line that goes through prices. Remember the VWAP is an average, which means it lags. Typically, when VWAP slopes up, it indicates prices are trending up, and when it slopes down, prices may be trending down. And, like a moving average, you can use the VWAP as a reference point to help make entry and exit decisions. In thinkorswim, you’ll notice two bands—one above and one below the VWAP. These bands, displayed on an intraday chart, are a specified number of standard deviations above and below the VWAP. Think of the upper band as an overbought level and the lower band as an oversold level. 

VWAP Trading: How to Use It

Stocks typically go through periods of trends or consolidations. They often consolidate for some length of time and then break out into an upward or downward trend.

One way to understand the VWAP is to observe price action as it approaches a significant line on the chart. In figure 1, you see that prior to the open, there’s a price consolidation. VWAP is relatively flat, or low momentum. When the markets opened, momentum increased and, in this case, price moved below VWAP and approached the lower band but didn’t quite reach that lower band. Price moved back up, broke above VWAP, and reached the upper band, which acted as a strong resistance level. See how the price bar broke above the upper band and then quickly retraced back toward VWAP? It stayed there for a couple of bars, i.e., the support level, but then broke below it and moved toward the lower band.

This time, it reached the lower band, went below it, and then started moving back up. After a few bars, it tested the lower band again. It then moved back up toward VWAP and sort of settled there for a little while. This suggests momentum could be slowing down.

In afternoon trading, prices started moving back down toward the lower band and hung out there for a while. The lower band acted as a support level and VWAP as a resistance level.

It doesn’t have to always be this way. Sometimes, VWAP may be the support level and the upper band the resistance level—it all depends on the market action. 

About two hours before the close, momentum started picking up with prices gravitating toward the lower band, sometimes breaking below it. During the last hour of trading, you could see prices moving above the lower band. But the markets are about to close, and the slight decline in VWAP suggests a downward trend and lower volume. Momentum comes to a crawl after the market closes.

Watching price action gives you some indication of the buying or selling activity. Say price moves below VWAP, and within a few bars, closes above it. This could mean buying activity has picked up and price could move toward the upper band. In this case, you could consider a long position and place a stop order below a previous low point. Your exit target could be any strategy such as a previous high, the upper band, or any other technical indicator. As with most indicators, VWAP may be more effective when combined with another indicator such as the Relative Strength Index (RSI) or moving averages.

VWAP is a dynamic indicator calculated for one trading day. But that doesn’t mean you can’t use VWAP on longer time frames. On a daily chart, you may just see the VWAP line (see figure 2), which you could use to identify trends and price reversals. Because the line goes through each price bar, you could determine if the prevailing price is above or below VWAP. 

The VWAP calculation for the day comes to an end when trading stops. At the next open, a new VWAP starts ticking, unrelated to what happened the previous day.