If you thought that we are talking about a moving average, that’s not entirely true. The indicator offers significant advantages over traditional options of moving averages. In combination with other indicators, it can improve the accuracy of your trading strategy.
VWAP shows where at the moment the coin is traded relative to its average daily volume.
Using VWAP, those who are engaged in Day-Trading determine the direction of the market movement and filter trading signals.
They also estimate how successful the deal was; made by comparing the price at which the order was executed at each specific time interval with the average price of transactions at the time interval.
To use an indicator correctly, it is important to understand where it comes from, how to interpret it and what its disadvantages are.
The heart of the matter
Initially, VWAP and TWAP are clever ways of algorithmic trading. Using them, you can sale a large volume without affecting the market, with a minimum risk and loss.
Trading with large amounts in one transaction is dangerous for three reasons:
- such a deal can significantly affect the market situation.
A one-time filling of a large order can cause a sharp drop/increase in the asset price, as demand rises strongly.
- There is no guarantee that a second party - the buyer or the seller - will be found for the entire transaction volume.
- One-time sale of a large volume can cause technical delays due to too much load on the systems.
Therefore, selling a large amount is not profitable. If there is no sufficient supply or demand on the market, the only part will be sold. The rest of the position — usually large portion — will be realized later. This means the worst price is threatened, which can lead to negative slippage. In such a situation, exchange rate risks inevitably arise — they are called “settlement risks”.
That’s why we need an “algorithmic trading” - smart trading of a large volume by small pieces.
Basic algorithm tasks:
- Split the position volume into small orders;
- Calculate the average selling price of the position and the best price for each specific order;
- Select the time and frequency of orders executing;
- Determine the type of order executing on the market: limit (pending) or market order.
Algorithmic strategies are conventionally divided into execution strategies and speculative strategies.
Thanks to the execution strategies, the algorithm sales the volume in small pieces, each time calculating the weighted average price. VWAP and TWAP are the means to calculate this price.
The algorithm TWAP — Time Weighted Average Price — calculates the weighted average price by time criterion. And this is what makes it less useful.
The algorithm executes buying or selling position in a specified time interval, splitting it into equal pieces.
It places market orders at a certain time interval at the best current price. The best price is the price closest to the cost of the first order executing.
Suppose someone wants to buy 100,000 coins today. TWAP automatically splits the total transaction volume into 79 orders, of which 76 orders will be 1,300 coins, and 3 orders - 400 coins each. Then, TWAP will fill them on the market at 5-minute intervals.
This is how someone may buy a large amount without affecting the market, as would occur if the entire volume was sold at the same time.
The algorithm TWAP is often accused of being primitive and contrasted with the algorithm VWAP, which is considered more advanced. The main problem of TWAP is its predictability. Other market players easily discover a strategy and play against it.
The algorithm VWAP — Volume weighted average price —is the ratio of the value traded to total volume traded over a particular time horizon.
The moving average indicator is most often based only on the closing price of the asset and does not provide accurate information about the true average price. That’s because for its calculation the actual number of transactions at different prices is required. This is what VWAP can do.
How does VWAP work?
During one trading session, VWAP splits the total position volume into small orders. At the beginning and at the end of the day, it exposes larger order volumes, and in the middle of the day - the lower ones — that is what TWAP cannot do by definition.
VWAP analyzes the average trading volume over a 5-minute interval and historical data on the first transaction volume. Based on above, it calculates each order volume. Then it places a market order at every 5-minute interval. The order contains the volume corresponding to the rated proportion. Since the order is placed at the best price, it is usually executed.
Attention! Here is an equation.😆 It is given to make you sure that VWAP is the sum of the current volume and price divided by the total volume placed on the market.
Equation to calculate VWAP (well, we’ve warned you 😎)
- V(t) – total trading volume at t;
- t - time interval;
- t1 - first time interval;
- t2 - current time interval
- P (t) - price at t.
As a rule, traders calculate VWAP for a day, but it is possible to apply it on other time frames: 1, 5, 10, 15, 30, or 60 minutes, a week, or a month.
Trading with VWAP
It's simple: when the price is above the line, an uptrend prevails. Conversely, if the price is lower than VWAP – a downtrend prevails.
VWAP on a bull market
VWAP on a bear market
VWAP on a flat market
What strategies VWAP gives:
- To buy when the price is lower than VWAP, as it can accumulate a position at a price that is better than the average market price.
- To close long positions and open short ones when the price is higher than VWAP.
- When the price crosses the VWAP line, you can regard it as an uptrend signal — and look for an opportunity to buy. It also works the other way around: when the price is below the VWAP line, it can be considered as sell signals.
VWAP line and price
- Strong buying pressure above VWAP shows that price forces market participants to reach a new high.
- Strong selling pressure below VWAP — is a sign that the price is pushing down to a new minimum.
Often, VWAP turns out to be support or resistance; it can be used in your strategy to determine dynamic levels:
VWAP acts as dynamic support or resistance level
Disadvantages of VWAP
If you thought you had just found the Holy Grail, bad news for you. VWAP is an excellent moving average indicator, and like any moving average indicator, its great disadvantage is lagging.
This is due to its cumulative formula.
It looks like that:
If you are working on a 5-minute chart, after 4 hours of trading, VWAP will be calculated for 48 periods. The associated delay will be similar to the 48 periods of the moving average:
A discrepancy between VWAP and SMA (48)
During the day, the volume accumulates — this lag will increase and by the end of the day will reach the maximum value. The fact is that the calculation already takes into account so many data that the new data have extremely little impact.
So, for low volume trading, VWAP is good at the beginning of the day, because at this moment it is more sensitive to price movements. At the end of the day, VWAP is smoothed out and would be of little value for the retail traders.
In the evening, using its values, you can solve another problem: the indicator’s cost provides a benchmark by which you can compare your accumulated positions with the average market price.
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