VWAP Indicator: Breakout and Pullback Trading Strategies

What Is the VWAP Indicator?

The VWAP indicator, or Volume Weighted Average Price, is a technical analysis tool that traders use to find the average price of a security throughout the trading day, adjusted for trading volume.

In simpler terms, it calculates the daily average price of a stock but gives more weight to the prices where more people have bought and sold the stock.

Understanding the VWAP Indicator

As mentioned above, the VWAP indicator takes into account the trading volume.

For example, if a large number of shares are traded at a particular price, this price will heavily influence the VWAP, making it a more realistic representation of the market's sentiment.

Moreover, VWAP is calculated continuously throughout the trading day, providing real-time data to traders. This allows them to see the average price based on all the transactions that have occurred up to that point in the day.

Additionally, this technical analysis indicator helps traders understand market conditions by whether a security trades above or below its average price.

• Price above the VWAP => The security is trading at a higher value, indicating a bullish trend.

• Price below the VWAP => The security is trading at a lower value, pointing to a bearish trend.

How to Calculate VWAP

While most modern trading platforms automatically calculate and integrate the VWAP indicator for you, it’s still beneficial to understand the VWAP calculation process.

Calculate the Typical Price

The Typical Price is the average of a security’s high, low, and close prices for a specific time period.

Multiply the Typical Price by the Volume for Each Period

TPV stands for Typical Price Volume, which is the product of the Typical Price and the trading volume for that period.

This step accounts for the impact of trading volume on the price.

Calculate the Cumulative Total of TPV and Volume

Throughout the trading day, keep a running total of the TPV and Volume values.

Divide the Cumulative TPV by the Cumulative Volume

This final step gives you the VWAP formula. It represents the average trading price, weighted by volume, for the day up to that point.

You might find it written like the below in some places, but it indicates the same value. 

Difference between the VWAP Indicator and Other Indicators

The VWAP indicator is often compared to other technical indicators but has unique characteristics that set it apart.

By comparing the VWAP with other indicators, we can better understand its importance and how it can enhance trading strategies.

Anchored VWAP vs. VWAP

The standard VWAP resets at the start of each trading day, making it an invaluable indicator for intraday analysis.

The Anchored VWAP, on the other hand, allows traders to choose a specific starting point in time from which the VWAP calculation begins.

This starting point can be any significant event, such as the beginning of a new quarter, the release of important financial news, or a major price movement.

By anchoring the VWAP to a particular point, traders can analyze the price action and volume from that specific event forward.

The below table summarizes the main key points of the anchored VWAP vs. VWAP indicator.

Therefore, while the standard VWAP is ideal for daily trading analysis, the Anchored VWAP is better suited for analyzing specific events.

VWAP vs. MVWAP

The MVWAP (Moving Volume Weighted Average Price) builds on the VWAP by extending its calculation over a longer period, similar to a moving average.

Unlike the VWAP, which resets daily, the MVWAP looks at VWAP values over several days or weeks. This approach helps traders identify longer-term trends and smooth out price movements.

The below table summarizes the main key points of the MVWAP vs. VWAP indicator.

As a result, the MVWAP is ideal for traders who need a broader perspective on a stock's performance over time, rather than just focusing on a single day's activity.

VWAP vs. Moving Average

We already explained how the VWAP indicator reflects the day's trading activity more accurately since it considers the number of shares traded at each price.

On the other hand, a Moving Average, such as the Simple Moving Average (SMA) or Exponential Moving Average (EMA), calculates the average price over a specified period, like 10 or 50 days.

• The SMA averages the closing prices over this period, giving equal weight to each day's price.

• The EMA, however, gives more weight to recent prices, making it more responsive to new information.

While Moving Averages are excellent for spotting longer-term trends and smoothing out price fluctuations, they don't account for trading volume.

The below table summarizes the main key points of the MVWAP vs. moving average.

Therefore, the VWAP is ideal for intraday traders, while the moving averages are better suited for identifying long-term trends and making strategic decisions over a more extended period.

How to Trade with the VWAP Indicator

When used correctly, trading with the VWAP indicator can be a highly effective strategy. Here’s how you can incorporate the VWAP into your trading plan.

Traders follow two main advanced VWAP strategies : the VWAP breakout and the VWAP pullback.

VWAP Indicator Breakout Trading Strategy

One of the strategies traders swear by is the VWAP Breakout Strategy. This method focuses on the Volume-Weighted Average Price (VWAP) to identify key breakout points that can trigger significant price movements.

The VWAP indicator is considered a major resistance level, so breaking it can lead to a noticeable price increase. This is called the VWAP crossover.

For stocks that have been heavily shorted, breaking above the VWAP can cause a sudden, sharp rise in price, sometimes even stopping trading temporarily because of how fast the price is climbing.

This increase is caused by bearish traders covering their short positions while bullish traders trying to capitalize on this golden entry opportunity.

Correct Entry Point for the VWAP Breakout:

• Entry Just Below VWAP: This approach can be risky because the stock may fade off the VWAP.

• Entry on Breakthrough: A better entry point occurs when the stock breaks through the VWAP. However, this method can also be risky if it turns into a bull trap and the price reverses quickly.

• 1-Minute Micro-Pullback: A safer strategy involves buying during a 1-minute micro-pullback after the VWAP breakout. This technique can lower the risk of immediate reversals and leverage the breakout momentum.

Profit Targets, Max Loss, and Risk Factors:

• Profit Targets: A profit target of 10% is often set for stocks priced under $20.00. However, if the stock shows signs of peaking earlier, it might be better to sell and secure the gains.

• Max Loss: The maximum loss is typically set just below the VWAP. The breakout setup is invalidated if the stock fails to maintain its position above the VWAP.

• Risk Factors: The primary risk is that bearish traders could push the stock back below the VWAP, causing bullish traders to lose confidence. The principle of "breakout or bailout" is critical—if the breakout fails, it's essential to exit the trade promptly.

VWAP Indicator Pullback Trading Strategy

In addition to the breakout strategy, traders also use the VWAP Pullback Strategy.

This strategy is particularly effective when a stock remains above the VWAP for most of the time, indicating strong bullish support.

Entry for the VWAP Pullback Strategy

• 5-Minute Bull Flag Pattern: The entry point is typically based on a 5-minute bull flag pattern, with a stop set just below the VWAP. This pattern indicates a temporary consolidation before the stock continues its upward trend.

• Close to VWAP: Another entry strategy involves buying as close to the VWAP as possible, with a stop just below the support level. This method capitalizes on the VWAP as a strong support level that, if held, indicates continued bullish momentum.

Profit Targets, Max Loss, and Risk Factors

The profit target for this strategy is usually the re-testing of the day's high.

If the stock shows strong momentum, additional bull flags on the 5-minute chart can indicate further upward movement.

However, to minimize losses, it's crucial to sell if the price breaks below the VWAP support.

VWAP’s Application Across Different Timeframes

The volume weighted average indicator is most commonly used on intraday charts, where it resets at the beginning of each trading day.

This resetting feature makes VWAP particularly well-suited for analyzing the daily activity of a security, helping traders identify average prices and gauge market sentiment within a single trading session.

Intraday Timeframes

VWAP excels as an intraday indicator because it captures the daily price movement while factoring in volume, providing traders with real-time insights on whether the price is relatively high or low compared to the day's average.

Intraday traders frequently use VWAP as a dynamic support and resistance level, as well as a benchmark for determining optimal entry and exit points.

Limitations in Higher Timeframes

Since VWAP resets each day, its effectiveness diminishes on longer timeframes, such as daily, weekly, or monthly charts. For swing traders or investors analyzing longer-term trends, VWAP’s cumulative calculation may introduce significant lag.

This lag effect, caused by the VWAP’s reliance on intraday data, means it doesn’t provide as accurate trend signals for higher timeframes as other indicators, like moving averages, which continuously calculate without resetting.

VWAP’s Application Across Market Types

The VWAP indicator is effective in various market types, but its performance and reliability can vary depending on the liquidity and trading volume of the asset.

High-Liquidity Markets

VWAP is particularly effective in high-liquidity markets, such as large-cap stocks, major indices, and heavily traded futures.

In these markets, the volume data is solid, and VWAP can accurately reflect the true average price by accounting for the distribution of trades.

High liquidity ensures that VWAP calculations remain stable and meaningful, allowing it to serve as a reliable benchmark for intraday trends.

Low-Liquidity Markets

In markets with lower liquidity, such as small-cap stocks or thinly traded securities, VWAP may become less reliable.

Limited trading volume in these markets can lead to erratic price movements and volume spikes that can distort VWAP’s value. For instance, a few large trades could disproportionately impact the VWAP calculation, making it an unreliable indicator for assessing true market sentiment.

In these cases, traders often supplement VWAP with other indicators that are less volume-sensitive.

Volatile Markets

During periods of high volatility, VWAP may behave differently, as abrupt price swings and large-volume trades can impact its accuracy as a support and resistance indicator.

While VWAP can still be useful, traders might need to exercise caution and adapt their strategies, possibly combining VWAP with other indicators to confirm trend reversals or breakouts in such volatile environments.

VWAP Trading Benefits

Here are the main benefits of trading with the VWAP indicator:

• Accurate Market Sentiment: Reflects true market sentiment by incorporating trading volume.

• Optimal Entry/Exit Points: Helps identify the best times to buy and sell.

• Support and Resistance Levels: Acts as a dynamic support or resistance level.

• Real-Time Data: Provides continuous updates throughout the trading day.

VWAP Indicator Limitations

Although the VWAP indicator provides valuable insights, it also has certain limitations that you should keep in mind:

• Lagging Indicator: VWAP uses cumulative data, so it reacts slowly to sudden price changes and lacks predictive power.

• Limited to Intraday Use: VWAP resets daily, making it most useful for intraday trading and less effective for longer-term trends.

• Inaccurate in Low-Liquidity Markets: Low-volume assets can skew VWAP calculations, leading to unreliable signals.

• Weakness in Strong Trends: VWAP may not provide reliable entry points in strong trending markets, as prices can consistently stay above or below it.

Conclusion

In conclusion, the VWAP indicator is more reliable than other indicators due to it taking into account the trading volume. It's especially helpful for intraday analysis and spotting optimal entry and exit points.