“Did I get a good price?”
Anyone who has traded a security has asked themselves this question. Did you buy when the stock was low enough? Did you sell right before it peaked? Did you get it wrong entirely and buy at the stock’s peak or sell when it had bottomed out? There is no clean answer to that question. But a metric called volume weighted average price (VWAP) is a good place to start, because it values shares on both their price and trading volume.What Is Volume Weighted Average Pricing?
Volume weighted average price (VWAP) is a way of measuring the price of a single stock or security. (For ease of use, in this article we will discuss stock prices. However, VWAP can apply to any market-traded security.) It measures the average price that a stock has traded at over the course of a day when accounting for both trading volume and price.
The VWAP is measured over each trading day. On a tick chart, it will show up as a line following the price movements of the stock over time.What Is the Value of the VWAP?
The VWAP offers several key pieces of information to traders.
First, by weighting for trade volume the VWAP can reflect a stock’s actual value to investors more accurately than simple price ticks. To understand this, suppose that ABC Co. stock had two segments of trading in a single day. At 9:30 a.m. traders exchanged 100,000 shares of the company’s stock for $10. At 4:30 p.m. traders exchanged 500 shares of ABC Co. stock for $50.
Yes, ABC Co. ended its day trading at five times where it started. But should we really consider that second trade as important as the first one, considering that it reflected a fraction of the stock’s actual activity over the course of the day?
Second, VWAP allows investors to track data over the course of the trading day.
As we will discuss below, the VWAP calculation is a moving formula. It shows the trader a stock’s weighted average price as a trading session advances, allowing the trader to see if that has moved in any significant direction.
Finally, the VWAP tells you how a stock is likely to do going forward. Prices over a single day’s trading can range widely. As a result, it can be difficult for traders to judge whether any given price is a good one at which to enter or exit a position.
The VWAP attempts to help traders answer that question. Investors who use it try to buy in when a stock’s price dips below the weighted average. This is their benchmark for when the stock is trading below value. They then try to sell once the stock’s price goes above the VWAP line, as anything above this price is considered above the stock’s value. It creates a trading benchmark for how a trader should consider pricing information at any given moment.Limitations of the VWAP
Arguably the greatest single limitation of the VWAP, which is a more aggressive approach to investing than the buy-and-hold approach, is that it is a single-day average.
The VWAP formula cannot account for historic trading information. This can lead to particularly misleading results if a stock is trading against its prior averages. The VWAP model will not reflect a stock that has been steadily rising for several days, nor can it reflect an asset in free fall. It can only show how a stock has performed over the course of a single day’s trading, absent any and all context.Calculating the VWAP
The VWAP formula is fairly simple:
VWAP = (Typical Price x Interval Volume) / Cumulative Volume
There are five steps to calculating a stock’s VWAP:
The VWAP is calculated over the course of a trading day, and is refreshed periodically to reflect the most recent trades. How often you want to do this depends entirely on the data set with which you’d like to work. Many, if not most, trading software calculates the VWAP based on every minute of trading. Others may calculate based on every three or five minutes, depending on resources.
Typical Price is the average of your interval’s High Price, Low Price and Closing Price.
So the formula would be: Typical Price = (HP + LP + CP) / 3
This is the price information for your given interval only.
Interval Volume is the volume of trading that took place specifically during this specific interval.
Cumulative volume is the total volume of trading that has taken place so far in the trading day.
Once you have run this formula for your given interval, repeat it for each subsequent unit of time. Collectively this will give you your VWAP tracking data over the course of the day.Sample VWAP Calculation
Say you’d like to calculate the VWAP for ABC Co. First, we will choose five minutes as our interval. This means that our calculation will run every five minutes, and each data point will reflect that interval’s trading activity. Collectively our VWAP will track the average price of ABC Co. over the course of the trading day, updated every five minutes.
Our first three intervals might have the following data:
High – $11.50
Low – $9.45
Close – $10.50
Volume – 15,687
High – $10.78
Low – $8.33
Close – $9.15
Volume – 22,374
High – $14.13
Low – $12.09
Close – $12.87
Volume – 12,115
Remember, in this context “closing price” means the price at which the interval closed. Our 9:00 – 9:05 closing price means that the last trade at 9:05 was made at $10.50.
Now we calculate our VWAP for the first 15 minutes of the trading day:
Typical Price = ($11.50 + $9.45 + $10.50) / 3 = 10.48
VWAP = (10.48 x 15,687) / 15,687 = $10.48
In our first interval, our Typical Price and our VWAP are the same. This is because at this point in the day our interval volume represents the only trading that has taken place. That’s about to change though.
Typical Price = ($10.78 + $8.33 + $9.15) / 3 = 9.42
Cumulative Volume = 15,687 + 22,374 = 38,061
VWAP = (9.42 x 22,374) / 38,061 = $5.54
Our cumulative volume is the total volume across the trading day, easily calculated as the current interval’s trading volume plus the cumulative volume of the interval before.
Notice how dramatically this swung the stock’s VWAP. This is because our numbers were significantly different from our first interval. The stock traded at much lower prices in much higher volumes, swinging its weighted average significantly down.
Typical Price = ($14.13 + $12.09 + $12.87) / 3 = 13.03
Cumulative Volume = 38,061 + 12,115 = 50,176
VWAP = (13.03 x 12,115) / 50,176 = $3.15
The stock’s price went up in this interval, but somehow its VWAP went down. This is a feature, not a bug. The formula has teased out the fact that, although prices went up trading volume was significantly down. As a result it shows that the stock’s value is likely weaker than the headline numbers suggest.The Bottom Line
Volume weighted average pricing, or VWAP, is a way of calculating a stock’s value over the course of a single day of trading. It creates a benchmark for trades based not only on the highs and lows of a stock price but also based on the amount of trading that occurred at those prices.Tips for Investing
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