There is a gap in the trading world between retail trader tools and professional trading tools. As retail traders run in hordes after complex lagging indicators, the trading desks at some of the world’s biggest funds and banks have a dirty open secret: they use simple but powerful Volume Weighted Average Price (VWAP).
Far from being a mere reference, VWAP indicates the actual average price of stock being traded and is therefore the arguiably most important benchmark for investors and traders. All that is answering a critical question: “What is the discount rate that makes this security’s fair value today, in light of where all the money actually has changed hands?”
For institutional traders, whose outsized orders can actually move the market, VWAP is the standard for quality of execution. For retail traders, knowledge of VWAP’s significance provides one of the few glimpses at what institutional investors are doing in the market and why they’re doing it. This guide will clarify VWAP and cover how traders use it, its value as a trading indicator, and whether or not the market exhibits the same pattern of behaviour.
What Exactly is VWAP? The “True” Average Price
Unlike a Simple Moving Average (SMA) that gives equal weight to every period, VWAP is calculated by multiplying the typical price (High+Low+Close)/3 by the volume for that period, summing these values, and then dividing by the total volume for the day.
In simple terms: VWAP = (Cumulative (Typical Price * Volume)) / (Cumulative Volume)
This calculation makes VWAP a dynamic, volume-aware average that resets at the start of each trading day. It’s not just a line on a chart; it’s the day’s consensus price. If a stock is trading above VWAP, it is, on average, being bought at a premium for the day. If it’s trading below VWAP, it’s being sold at a discount.
The Institutional Mindset: Why the “Smart Money” Cares
Institutions trade in size. When a pension fund wants to buy a million shares of a company, they can’t just hit the “buy” button. Their massive order would instantly spike the price, costing them millions in “slippage.” Instead, they use complex algorithms to drip their order into the market throughout the day.
Their primary goal? Execute their large orders as close to the VWAP as possible.
- If they are buying, their algorithms are programmed to be aggressive when the price is below VWAP (a discount) and passive when the price is above VWAP (a premium).
- If they are selling, they will be aggressive above VWAP and passive below it.
This institutional behavior creates predictable patterns around the VWAP line, which astute retail traders can exploit.
The VWAP Trading Strategy Toolkit
Here’s how to interpret price action relative to VWAP and turn it into a concrete trading plan.
1. The Trend Gauge: The Ultimate Intraday Bias
The most powerful VWAP signal is also the simplest.
- Bullish Bias: If price is consistently trading above a rising VWAP, the intraday trend is bullish. This indicates sustained buying pressure, and the path of least resistance is up. Your strategy should favor long positions.
- Bearish Bias: If price is consistently trading below a falling VWAP, the intraday trend is bearish. This indicates sustained selling pressure, and the path of least resistance is down. Your strategy should favor short positions.
The Golden Rule: Do not fight the VWAP. A long position taken below a falling VWAP is a low-probability trade, just as a short position above a rising VWAP is.
2. The Dynamic Support and Resistance Engine
VWAP is not a static line; it’s a dynamic level of equilibrium that acts as a magnet for price.
- In an Uptrend (Price Above VWAP): Pullbacks to the VWAP line often find support. This is where institutional buy-side algorithms re-enter the market. A bounce off VWAP with bullish volume confirmation is a high-probability long entry.
- In a Downtrend (Price Below VWAP): Rallies up to the VWAP line often find resistance. This is where institutional sell-side algorithms become active. A rejection from VWAP with increasing volume is a high-probability short entry.
Pro Tip: The first test of VWAP after a strong morning move is often the most reliable. The third or fourth test suggests the trend may be weakening.
3. The VWAP Displacement Breakout Strategy
Sometimes, price will make a sharp, high-volume move away from VWAP. This creates a “displacement” or a gap between price and its volume-weighted average. Like a stretched rubber band, price often has a tendency to snap back to VWAP.
- Strategy: After a sharp, extended rally far above VWAP, look for signs of exhaustion (e.g., a bearish reversal candle, divergence on the RSI). This can signal an opportunity for a mean-reversion short trade, with a profit target back near the VWAP line. The same logic applies in reverse for a sharp drop.
4. The VWAP “Squeeze” and Volatility Expansion
While not as common as with Bollinger Bands, a VWAP squeeze can occur. When price coils tightly around the VWAP with very low volume, it indicates a period of equilibrium and indecision. This compression often precedes a significant, high-volume breakout. The direction of the breakout from this tight coil, especially on a surge in volume, often sets the tone for the rest of the trading session.
Advanced VWAP Concepts: The 9:30 AM “Battle”
The most critical time for VWAP analysis is the first 30-60 minutes of the trading day. This is when institutions are establishing their positions, and a clear narrative forms.
- The VWAP Test: Institutional traders closely watch to see if the price can hold above or below the newly formed VWAP. A stock that gaps up at the open and then successfully holds a pullback above VWAP is showing incredible strength. Conversely, a failed test (e.g., price gaps up but then drops and closes below VWAP) is an extremely bearish sign.
- The VWAP Fade: This is a counter-trend strategy where a trader fades the initial move. For example, if a stock gaps up significantly at the open, a “fader” might short it, betting that the gap is overdone and the price will revert back down to touch the VWAP. This is a higher-risk, advanced tactic.
VWAP Do’s and Don’ts
- DO use VWAP on intraday timeframes (e.g., 5-min or 15-min charts). It resets daily, so it’s meaningless on weekly or monthly charts.
- DO combine VWAP with other confirming indicators, like a 9 or 20 EMA, or volume-profile analysis.
- DON’T use VWAP in isolation for a full trading system. It is a context tool.
- DON’T ignore volume. A VWAP bounce on low volume is weak. A VWAP bounce on high volume is a strong institutional signal.
Conclusion: Trading with an Institutional Edge
The VWAP is more than an indicator and the value of it goes beyond drilling down on it through math. Once you understand and use it, trading off lagging formulas will be a thing of the past! You are merging your trades with the fundamental structure of market—we basing our opinoin on a continous war between buyers and sellers in order to set up at last fair price.
You start to look at pullbacks or setbacks as not threats but adherents in the action of entering in the direction of institutional flow. You now have the courage to stick with winning trades a little while longer as you can quantify intraday strength. I have found that if you use VWAP as a reference point, you become a lot less like the spectator and more like the floor trader trading with rhythm, logic [of course, everything in this business must be paired with pricing] executing on where the “smart money” is.