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7 Reasons Day Traders Love the VWAP

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7 Reasons Day Traders Love the VWAP

7 Reasons Day Traders Love the VWAP

Learn How to Day Trade with the VWAP - Video

Before we dive into the 7 reasons day traders love the VWAP, let's first take a look at this short video which covers the meat of the VWAP trading strategies.

Learn to Day Trade the Right Way:: See how you can learn to to trade stocks, futures and bitcoin risk-free.

This video will serve as a great primer before you dig into the more advanced techniques and topics covered in this article.

VWAP Overview

Finding the average price based on closing value of a security will not give you an accurate picture of a stock’s health.

This is where the VWAP comes into play.

If you are wondering what is the VWAP, then wait no more. VWAP stands for volume weighted average price and it identifies the true average price of a stock by factoring the volume of transactions at a specific price point and not simply based on the closing price.

Did the stock close at a high with low volume?  Did the stock move to a new low with light volume?

These are all critical questions you would want answered as a day trader before pulling the trigger.

This is where the VWAP can add more value than your standard moving average indicator, because the VWAP reacts to price movements based on the volume during a given period.

In this article, we will explore the seven reasons day traders love using the VWAP indicator.

While we have highlighted day traders, what we will discuss in this article is also applicable for swing traders and those of you that love daily charts.

So, if you do not partake in the world of day trading, no worries, you will still find valuable nuggets of information in this post.

Now that your expectations are set, before we dig into why traders love the VWAP, let’s first walk through a few key concepts when using the indicator.

Most importantly, I want to make sure we have an understanding of where to place entries, stops and targets when using the VWAP.

Entries + Stops + Targets

Entries + Stops + Targets

VWAP Setups

After studying the VWAP on thousands of charts, I have come up with two basic setups: (1) pullback or (2) breakout.

By far, the pullback to the VWAP is the most popular setup for day traders as they are attempting to get the best value prior to entering the trade. Remember, day traders have only minutes to a few hours for a trade to work out.

The VWAP breakout setup is not what you may be thinking. I am not looking for a breakout to new highs, but rather a break above the VWAP itself with strength.

Now, let’s dig into the entry points for these setups.

VWAP Pullback Entry

Entry Option 1 – Aggressive Traders

Aggressive VWAP Trade

Aggressive VWAP Trade

The first option is for the more aggressive traders and would consist of watching the price action as it is approaching the VWAP.

Wait for a break of the VWAP and then look at the tape action on the time and sales.

You will need to identify when the selling pressure is spiking and the tape is going crazy.

This my friend is more art than science and will require you to practice reading the tape.

The goal is to identify when the selling pressure is likely to subside and then enter the trade.

This approach will break most of the entry rules you hear on the web of simply buying on the test of the VWAP.  The problem with this approach is you don’t know if the price will breach the VWAP by 1% or 4%.

I learned the hard way and if the VWAP was at $10, I would place my limit order at $10.  Needless to say, at times there were traders who could care less about the VWAP and it would slice through the indicator with such swiftness, the lasting sting to my psyche lasts until this day.

This technique of using the tape is not easy to illustrate looking at an end of day chart.  You will need to practice this approach using Tradingsim to assess how close you can come to actually calling the turning point based on order flow.


Entry Option 2 – Risk Averse Traders

Conservative VWAP Entry

Conservative VWAP Entry

This is what I would recommend to traders that are new to the VWAP indicator.

Essentially, you wait for the stock to test the VWAP to the downside. Next, you will want to look for the stock to close above the VWAP.

You will then place your buy order above the high of the candle that closed above the VWAP.

While this is a more conservative approach for trade entry, it will open you up to more risk as you will likely be a few percentage points off the low.

You will need to determine based on where you are in your trading journey and your appetite for risk to assess which entry option works best for you.

It goes without saying that while we have covered long trades; these trading rules apply for short trades, just do the inverse.

Now that you are in the trade, where should you place your stop?

Aggressive Trade Stop

Aggressive Stop Price

Aggressive Stop Price

If you take the aggressive approach for trade entry, you will want to place your stop at your daily max loss or at a key level (i.e. morning gap).

Again, this of course can work, but you need to be prepared for the wild swings that can occur if you get things wrong.

Pullback Stop

Conservative Stop Order

Conservative Stop Order

The pullback stop is simple to identify, it is the most recent low point.

Therefore, after you enter the trade, if the stock begins to rollover, breaks the VWAP and then cuts through the most recent low – odds are you have a problem.

At this point, you will want to close the trade and protect your capital.

VWAP Target

Target

Target

The target for the VWAP trade is my favorite part of this article, as I like to make money trading.

You have a few ways to determine your profit potential on each trade.

Selling at the Daily High

Sell at High of the Day

Sell at High of the Day

This is the most popular approach for exiting a winning trade for seasoned day trading professionals.  After entering the trade, you place your stop below the most recent low and then look to the high of the day to close the position.

You will notice that after the morning breakouts that occur within the first 20-40 minutes of the market opening, the next round of breakouts often fail.

This is because the seasoned traders are selling their long positions to the novice day traders who buy the breakout of the high as we go beyond the first hour of trading. This gives the seasoned traders the opportunity to unload their shares to the unsuspecting public.

In case you are wondering, yes, this is legal.

Selling at a Fibonacci Extension Level

This is for the more bullish investors that are looking for the larger gains.  This approach is based on the hypothesis that the stock will break the high of the day and run to the next Fibonacci level.

This target can represent huge gains, often in the 4% to 10% realm for day trades. This of course means the odds of hitting this larger target is less likely, so you will need to have the right frame of mind to handle the low winning percentage that comes with this approach.

There of course many other exit strategies, but these are my favorites.

Whichever methodology you use, just remember to keep it simple.  The market is the one place that really smart people often struggle.

Psychology of the VWAP Trade

If you have been trading for any length of time, you know the indicators and charts are just smoke and mirrors. Your success will come down to your frame of mind and a winning attitude.

So, let’s take a break from the quantitative and get more into the fuzzy area of state of mind.

Everything you need to make money is between your two ears

Everything you need to make money is between your two ears

The VWAP trade is something that I have tested quite a bit, and have achieved mixed results to date.

A pullback trade just makes sense when you look at it on paper.

You are not buying at the highs of the day, so you lower the distance from your entry to, let’s say the morning gap.  Thus reducing the amount of money you are risking on the trade if you were to just buy the breakout blindly.

Also, you are able to monitor and “size up” the trading activity as the stock shifts back and forth trying to find its footing at the VWAP.  This will allow you to maybe look at 2 to 4 bars before deciding to pull the trigger.

You can then begin to watch the volume to see if the selling on the pullback is purely technical or if there is real danger on the horizon.

Sounds really clean and neat uh?

Well, let me first walk you through what you will likely be thinking if a VWAP pullback trade does not go in your favor.

When things don’t go so well

First off, you will be shocked, depending on how much you love the VWAP. You may find it hard to believe that the indicator of all indicators is not working.

The next thing you will be faced with is when to exit the position.  If the stock shot straight up, it will be tough to find a pivot point without opening yourself up to a significant loss.

If the stock does have a close pivot point, you now are faced with the option of seeing if the price closes below the VWAP, or if it can reverse and hold its ground.

What should you do?

These are the kind of answers you need to have completely flushed out in your trading plan before you think of entering the trade.

The VWAP and quite frankly, no other indicator will address these internal questions/conflicts you will be facing.

These are things that you need to manage and keep under control if you want to have any success in the markets.

When things go just right

I do not want to paint this doom and gloom picture for you, so let’s shift to more of a positive tone.

Now, the flip side to this trade is when you get it just right.  I mean the stock pulls back to the VWAP, you nail the entry and the stock just runs back to the previous high and then breaks that high.

Talk about a feeling of mastery; it’s just lights out trading.

The stock will instantly go in your favor and depending on the volatility of the stock; you will find yourself up 2% to 3% without even blinking.

The money will literally fall into your account.

I have laid out these two scenarios, so that you get a feel for what it means to be in a losing and winning VWAP trade.

Simply knowing when you are in a winner or a loser and how quickly it takes you to come to that conclusion will be the deciding factor between an upsloping equity curve and one that runs into the ground.

Real-Life Trading Examples

Now that you have a handle on the basics and psychology behind the setup, let’s dig into a number of real-life trading examples.

Trump and Bank Stocks

Trump and Bank Stocks

Let’s cover a real-life example, so you can see how things don’t always go as planned, but you need to be prepared for anything.

Example 1 - VWAP Pullback Trade

In this trade example, we will review the Financial Sector ETF (XLF).

Why the XLF you might ask?

Well since the election of Donald Trump, banking stocks have been outperforming the broad market hand over fist, so I thought it would be great to highlight something that’s currently taking place in the market.

Banking Sector

Banking Sector

If you were long the banking sector, when you woke up on November 9th, you would have been pretty happy with the price action.

To that point, there was a clear VWAP day trade, but to Monday quarterback this a little, were things that obvious?

VWAP Pullback Trade

VWAP Pullback Trade

Notice how the ETF had a huge red candle on the open as it gave back the gains from the morning.  I would also like to highlight the gains were only there for a few seconds, because this is not apparent looking at a static chart.


As a trader, how would you know if XLF was going to crash back through the VWAP on the third candle or if it would go higher?

Remember, the election of Donald Trump was not expected, so it was really anyone’s call what would happen on the open.

Then XLF experiences a slight rally, only to rollover again and retest the VWAP.  Should you have bought XLF on this second test?

Notice how the XLF doesn’t hold the VWAP and actually trades below the indicator.

Now that I have completely confused you, these are just a few of the things I want to highlight, because these are likely the thoughts that will be running through your mind in real-time.

Another key point to highlight is that stocks do not honor the VWAP as if it is some impenetrable wall.

If you read other posts on the web about the VWAP, it gives you the impression that if a stock closes below the VWAP you have to run for the hills.

This is the furthest thing from the truth.

There are automated systems that push prices below these obvious levels (i.e. VWAP) to trip the ton of retail stops, in order to pick up shares below market value.

In addition, while you may be looking at the VWAP, there are a ton of traders who could care less and do not have the indicator on their chart.

Therefore, what is so apparent to you is not even on another trader’s radar.

Now, back to the trade.

The last thing that made this trade difficult is the volume action on the break above the VWAP didn’t scream buy me.

However, if you look a little deeper into the technicals, you can see XLF made higher lows and the volume, albeit lighter than the morning, is still trending higher.

Once XLF was able to get back above the VWAP with steadily increasing volume, it never looked back.

Again, not the perfect setup technically, but if you can read in-between the lines, you could see the potential of the trade.

Remember as a trader, we are not here to guess how the news will affect prices; we just trade whatever is in front of us.

Example 2 - VWAP Breakout Trade

Let’s dig a little deeper into VWAP breakout trades and the volume associated with these moves.

Volume to me is the lens you can apply to the market, which can make sense of all the chaos and noise.

VWAP Trade

VWAP Trade

This is a trade of Buckeye Partners, LLP where you can see the stock stayed below the VWAP for some period of time.

Then BPL was able to climb above the VWAP, but started to just hang around.

At this point, you could jump into the trade, since the stock has been able to reclaim the VWAP, but from what I have observed in the market, things can stay sideways for a considerable amount of time.

Remember, it’s not just about placing trades; you need to place trades that will make the best use of your time and money.

The key thing you want to see is price increase with significant volume.  Will you get the lowest price for a long entry- absolutely not.  However, you will receive confirmation that the stock is likely to run in your desired direction.

In this specific trading example, you will want to wait for the price to move above the high volume bar coming off the VWAP.  This is a sign to you that the odds are in your favor for a sustainable move higher.

As a day trader, remember that move higher could take 6 minutes or 2 hours.  You will have to judge the speed at which the stock clears certain levels in order to determine when to exit your long position.

Make sense?

VWAP and Confluence

Chicken and Waffles

Chicken and Waffles

So, you could be asking yourself. “What does chicken and waffles have to do with trading?”

Everything.

In trading, one signal is ok, but if multiple indicators from varying methodologies are saying the same thing, then you really have something special.

If you are unfamiliar with the concept of confluence, essentially you are looking for opportunities where another technical support factor is at the same price of the VWAP.

For example, a Fibonacci level or a major trend line coming into play at the same level of the VWAP indicator.

Confluence

Confluence

This confluence can give you more confidence to pull the trigger, as you will have more than just the VWAP giving you a signal to enter the trade.

This brings me to another key point regarding the VWAP indicator.  There are great traders that use the VWAP exclusively.  However, these traders have been using the VWAP indicator for an extended period of time.

When starting out with the VWAP, you will not want to use the indicator blindly. I’m not suggesting you throw 10 indicators on your chart for confirmation, but you will need to use some other validation tool to ensure you are seeing the market clearly.

Finding VWAP Trades

Timing is everything in the market and VWAP traders are no different.  While stocks are always trading above, below, or at the VWAP, you really want to enter trades when stocks are making a pivotal decision off the level.

To do this, you need to have the ability to scan for these setups in real-time.

If you have more than one criteria for entering trades, you will likely dwindle down the huge universe of stocks to a much more management list of 10 or less.

However, if you purely trade based on the VWAP, you will need a way to quickly see what stocks are in play.

To do this you will need a real-time scanner that can display the VWAP value next to the last price. You can then do a crosswalk of the VWAP with the current price to identify volatile stocks that are testing the indicator.

VWAP Scanner

VWAP Scanner

You are probably asking what are those numbers under the symbol column.  For those of you that don’t know, I trade the Nikkei at night from the States.

While I did not highlight every symbol that is coming close to or testing the VWAP, you can get the point.

Another option if you have the ability to develop a custom scan is to take the difference of the VWAP and the current price and display an alert when that value is zero.

Essentially, this is the numerical representation that the price and VWAP are overlapping.

7 Reasons Day Traders Love the VWAP

I’m hoping that the information thus far has increased your level of understanding when it comes to the VWAP indicator.

Now, we can shift into what first caught your attention – the 7 reasons day traders love the VWAP!

Reason # 1: VWAP Calculation Factors in Volume

For the record, the VWAP formula is:

∑ Number of Shares Purchased x Price of the Shares ÷ Total Shares Bought During the Period

As you can see, by multiplying the number of shares by the price, then dividing it by the total number of shares, you can easily find out the volume weighted average price of the stock. Since the VWAP takes volume into consideration, you can rely on this more than the simple arithmetic mean of the transaction prices in a period.

Theoretically, a single person can purchase 200,000 shares in one transaction at a single price point, but during that same time period, another 200 people can make 200 different transactions at different prices that do not add up to 100,000 shares.

In that situation, if you calculate the average price, it could mislead, as it would disregard volume.

Reason 2 #: VWAP Can Enable Day Traders to Buy Low and Sell High

If your technical trading strategy generates a buy signal, you probably execute the order and leave the outcome to hopes and prayers. However, professional day traders do not place an order as soon as their system generates a trade signal. Instead, they wait patiently for a more favorable price before pulling the trigger.

Figure 1: Price of AAPL Compared to Its 5-Minute VWAP

Price of AAPL Compared to Its 5-Minute VWAP

If you find the stock price is trading below the VWAP indicator and you buy the stock at market price, you are not paying more than the average price of the stock for that given period.

With VWAP trading, you can stick to a trading strategy where you can always buy low.

By knowing the volume weighted average price of the shares, you can easily make an informed decision about whether you are paying more or less for the stock compared to other day traders.

Reason # 3: A VWAP Cross Can Signal a Change in Market Bias

Buying low and selling high is all-great; however, if you are a momentum trader, you would look to buy when the price is going up and sell when the price is going down, right?

 

Figure 2: AAPL Crossing Above VWAP

AAPL Crossing Above VWAP

A VWAP strategy called the VWAP cross can help you locate and trade momentum in the market.

Since the VWAP indicator resembles an equilibrium price in the market, when the price crosses above the VWAP line, you can interpret this as a signal that the momentum is going up and traders are willing to pay more money to acquire shares.

When you find the price is crossing below the VWAP, you can consider this as a signal that the momentum is bearish and act accordingly.

Reason # 4: VWAP Can Act as Dynamic Support and Resistance

Figure 3: BONT Price Respecting VWAP Resistance

BONT Price Respecting VWAP ResistanceDay traders love the VWAP indicator because more than often the price finds support and resistance around the VWAP. Although this is a self-fulfilling prophecy that other traders and algorithms are buying and selling around the VWAP line, if you combine the VWAP with simple price action, a VWAP strategy can help you find dynamic support and resistance levels in the market.

You should note that the likelihood of a VWAP line becoming a dynamic support and resistance zone becomes higher when the market is trending.

Reason # 5: VWAP Can Help You Confirm Counter Trend Trading Opportunities

 

Figure 4: VWAP Confirms the Oversold Signal Generated By the RSI Indicator

VWAP Confirms the Oversold Signal Generated By the RSI Indicator

Ever wondered if a stock is overbought or oversold and if this is the right time to take a counter trend trade?

If you are just looking at the RSI or Stochastics and double guessing if this is a strong trend or the market will turn back, then adding the VWAP indicator on your chart can make your life much easier.

Professional day traders have a rule of thumb when using the VWAP - if the VWAP line is flat lining, but the price has gone up or down impulsively, the price will likely return to the VWAP line. However, if the VWAP line is starting to gradually go up or down along with the trend, it is probably not a good idea or good time to take a counter trend position.

Reason # 6: VWAP Can Help You Reduce Market Impact

Most day traders do not understand that their actions can affect the market itself because we often trade our personal funds at the retail level. However, if you are a hedge fund manager or in charge of a large pension fund, your decision to buy a stock can drive up the price.

Just imagine for a second you are day trading and want to buy 5,000 shares of Apple (AAPL).

AAPL is a fairly popular stock and traders rarely face any liquidity problems when trading. Hence, you will have no trouble finding a seller willing to let go of his 5,000 AAPL shares at your bid price.

However, if you want to buy 1 million AAPL shares within 5 minutes and place a market order, you will probably buy up all the AAPL stock on sale in the market at your given bid price within a second. Once that happens, your broker will fill the rest of your order at any price imaginable, but probably higher than the current market price.

Congratulations, you have just bid the price up and impacted the market!

Placing a large market order could be counterproductive, as you will end up paying a higher price than you originally intended. Hence, when you want to buy large quantities of a stock, you should spread your orders throughout the day and use limit orders.

If you find the stock price is trading below the VWAP, you are paying a lower price compared to the average price, right? This way, a VWAP strategy can act as a guide and help you reduce market impact when you are dividing up large orders.

You may think this example only applies to the big boy, but wait until you want to buy 10k shares of a low float stock.  You will soon find out that the stock may only trade 500 shares or less every 5 minutes.

Good luck trying not to bid up the price if you want to scoop up those 10k shares right away.

Reason # 7: VWAP Can Help Beat High Frequency Algorithms

They are watching you - when we say they; we mean the high frequency trading algorithms. Have you ever wondered why the liquidity levels in the stock market have gone up over the last few years?

The high frequency algorithms can act as little angels when liquidity is low, but these angels can turn into devils as the attempt to bid up the price of a stock by placing fake orders only to cancel them right away.

If you are emotionally following the tape, you may start executing market orders because you are worried the price will run away from you.

This is where the VWAP can come into play. Instead of focusing on the level 2, you can place limit orders at the VWAP level to slowly accumulate your shares without chasing these phantom orders.

Conclusion

VWAP Conclusion

VWAP Conclusion

Once you apply the VWAP to your day trading, you will soon realize that it is like any other indicator.  There are some stocks and markets where it will nail entries just right and others it will appear worthless.

If you use the VWAP indicator in combination with price action or any other technical trading strategy, it can simplify your decision making process to a certain extent.

For example, there are many practical applications of VWAP when you are trading large quantities of shares to ensure you are not paying more than market value over a period of time.

Just remember, the VWAP will not cook your dinner and walk your dog. You still need to make sound trade decisions based on what the market is showing you at a particular point in time.

If you have any question about VWAP or want to discuss your experiences with the VWAP, please share it in the comments section below.

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