How to Use Volume-Weighted Indicators in Trading

Volume is generally considered one of the drivers of momentum, which is why some chartists keep an eye on volume regardless of what indicator they're using. Some technical traders prefer to add subcharts of volume-based indicators like 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.

VWAP is the average price of a stock weighted by volume. By monitoring VWAP, a trader might get an idea of a stock's liquidity and the price buyers and sellers agree is fair at a specific time. The VWAP indicator can be used by day traders to monitor intraday price movement. Institutions and algorithms might use VWAP to figure out the average price of large orders.

VWAP is calculated using the cumulative total of the price of each trade, multiplied by the volume of that trade, and then divided by total volume traded for the day.

A trader can plot VWAP on thinkorswim^® charts without using the formula. From the Charts tab, add a symbol, and bring up an intraday chart. 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 might be trending up, and when it slopes down, prices might be trending down. And, like a moving average, a trader can use VWAP as a reference point to help make entry and exit decisions. On thinkorswim, there are two additional 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. The upper band might be considered an overbought level and the lower band might be considered an oversold level.

One trait of VWAP is that it's calculated from the time the market opens to when it closes. A trader can potentially see price and volume action unfold in real time during a specific time in the trading day, providing information short-term traders might use when executing their trades.

Stocks typically go through periods of trends or consolidations. They might 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 the above image, it's possible to see a price consolidation prior to the open. VWAP is relatively flat or has 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 it. Price moved back up, broke above VWAP, and reached the upper band, which acted as a strong resistance level. On the chart, the price bar broke above the upper band and then quickly retraced back toward VWAP. It remained for a couple of bars, at the support level, but then broke below it and moved toward the lower band.

This time, when the price bar reached the lower band, it 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 remained somewhat steady. This might suggest momentum could potentially be slowing down.

During afternoon trading, prices started moving back toward the lower band, with the lower band acting as a support level and VWAP as a resistance level.

However, this isn't always the case. Sometimes the market action results in the VWAP acting as the support level and the upper band acting as the resistance level.

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, prices began moving above the lower band. As the markets closed, the slight decline in VWAP suggests a potential downward trend and lower volume. Momentum usually comes to a crawl after the market closes.

Watching price action can provide a trader with some indication of buying or selling activity. If a price moves below VWAP, and within a few bars, closes above, it could be an indication that buying activity has picked up and the price could move toward the upper band. In this case, a trader might consider a long position and place a stop order below a previous low point. An exit target could potentially be a previous high, the upper band, or any other technical indicator. As with some other indicators, VWAP might be more effective when combined with another indicator like the Relative Strength Index (RSI) or moving averages.

VWAP is a dynamic indicator calculated for one trading day. On a daily chart, the VWAP line alone might be used to identify potential trends and price reversals. Because the line goes through each price bar, a trader 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 calculation begins, unrelated to what happened the previous day.