Day Trader's Toolbox Part 2: VWAP

25 ott 2023

Welcome to the Day Trader's Toolbox, a 3-Part series focused on enhancing your day trading skills.

In this second instalment, we delve into the intricacies of VWAP (Volume Weighted Average Price), a versatile indicator that can help you navigate intra-day price action.

I. Understanding VWAP:

What is VWAP?

VWAP calculates the average price at which a security has traded during a specified period, usually a trading day. It is unique in that it combines both price and volume data to provide a weighted average, reflecting not just where a stock has traded but also the volume at each price level.

How to Add VWAP to Your Charts

TradingView make it easy to add VWAP to your charts. Simply type VWAP into the indicators search bar. The VWAP line will appear as a continuous line on your chart, indicating the average price levels for the day. It offers a moving average of the price throughout the day, with the line calculated using intraday price data from the market open to the close.

VWAP is typically viewed on day trading timeframes (5min and 1min candle charts). VWAP resets at the open of each day, for this reason VWAP tends to become more useful as the trading day progresses.

Here’s how VWAP typically looks on your intraday price chart:
S&P 500 1min Candle Chart (Daily VWAP)

Past performance is not a reliable indicator of future results

II. 3 Ways to Use VWAP When Day Trading

1. Sentiment Analysis

VWAP is a powerful tool for analysing market sentiment, helping day traders understand the prevailing mood of the market. Here's how it works:

Bullish Sentiment: When the current price of a stock is holding above the VWAP line, it is often interpreted as a sign of bullish sentiment. This suggests that, on average, traders are willing to pay prices higher than the average daily price - indicating that buyers are in control.

Bearish Sentiment: Conversely, when the price of a stock is below the VWAP, it indicates bearish sentiment. In this scenario, traders are willing to pay prices lower than the average daily price, implying that sellers are in control.

Examples:
Price Holding Above VWAP (Tesla 1min Candle Chart)

Past performance is not a reliable indicator of future results

Price Holding Below VWAP (Tesla 1min Candle Chart)

Past performance is not a reliable indicator of future results

2. Trending Market: Dynamic Support and Resistance

In a trending market, where a stock is moving in a clear upward or downward direction, VWAP serves as dynamic support and resistance. Here's how day traders use VWAP in this context:

Dynamic Support: When a stock consistently trades above the VWAP line, VWAP acts as a dynamic support level. This means that, on average, the price of the stock remains above the VWAP, indicating a positive sentiment. Traders can use VWAP as a reference point to enter long positions, set stop-loss orders just below it, and potentially ride the trend for further gains.

Dynamic Resistance: Conversely, when a stock remains below the VWAP, VWAP acts as dynamic resistance. This suggests that the average trading price for the day is above the current price, signifying a bearish sentiment. Traders can use VWAP as a reference point for entering short positions and managing risk by setting stop-loss orders just above it.

In both cases, VWAP serves as a dynamic level that adapts to the intraday price movements, providing guidance on when to enter trades and where to place protective stops.

Examples:
VWAP Dynamic Support in Uptrend

Past performance is not a reliable indicator of future results

VWAP Dynamic Resistance in Downtrend in Uptrend

Past performance is not a reliable indicator of future results

Sideways Market: Spotting Market Extremes

VWAP can be particularly valuable in identifying extremes in a sideways or range-bound market. An upper and lower band can be placed 2 standard deviations above and below the VWAP line (click settings on your VWAP indicator on TradingView to add the bands). Here's how day traders use VWAP to spot market extremes:

Overextension Above VWAP: When a stock's price significantly extends above the upper VWAP band, it signals that price is more than 2 standard deviations away from the true average price for that day – leaving the stock vulnerable to mean reversion. Day traders can interpret this as a potential market extreme, suggesting that the stock may be overbought in the short term. This could be a signal for traders to consider taking profits on long positions or potentially entering short positions, anticipating a mean-reversion move back toward the VWAP.

Overextension Below VWAP: Conversely, when a stock's price significantly drops below the lower VWAP band, it could signal overselling or excessive bearish sentiment. In this case, day traders may view it as a potential market extreme, indicating that the stock may be undervalued in the short term. This could be a signal for traders to consider taking profits on short positions or potentially entering long positions, expecting a mean-reversion move back toward the VWAP.

Example:

VWAP bands signal extremes in sideways market

Past performance is not a reliable indicator of future results

In summary, VWAP, the Volume Weighted Average Price, is a valuable tool in a day trader's toolbox. It offers insights into market sentiment, dynamic support and resistance levels in trending markets, and extreme market conditions in sideways markets. As you continue your day trading journey, consider incorporating VWAP into your trading strategy to gain a deeper understanding of market dynamics.

Disclaimer: This is for information and learning purposes only. The information provided does not constitute investment advice nor take into account the individual financial circumstances or objectives of any investor. Any information that may be provided relating to past performance is not a reliable indicator of future results or performance.