Tuesday, February 03, 2009

Using VWAP to Determine the Structure of the Trading Day

A review of an earlier post is in order: a market's volume-weighted average price (VWAP) reflects the average price of transactions through the trading day. Knowing where we are trading during the day relative to that day's VWAP is very helpful in identifying the kind of day that we're in.

Above is a chart of yesterday's S&P 500 e-mini index (blue line) vs. its VWAP (pink line). We opened below the market's previous day's close and oscillated around VWAP in the early minutes of trade, moving both above and below the market's opening price. Advance-decline breadth was negative, and we saw a moderate negative bias to the NYSE TICK.

Had this been a strong downtrending day, we would have seen several things:

1) Price moving away (lower) from its opening level;

2) A downtrending VWAP line, as new transactions are occurring at lower price levels and lower prices are attracting further selling volume;

3) Price stays below the VWAP line, as recent transactions are occurring at lower price levels than earlier ones and the lower prices are attracting selling volume.

The fact that we were oscillating around the market opening price for much of the first half-hour of trade was an early indication that this was not shaping up as a strong downtrending day.

Indeed, with the 9 AM CT data, we saw an upside break above the opening range on a positive shift in NYSE TICK. As a result, we traded above VWAP and VWAP displayed an upward slope. If this were going to be a solid uptrend day, we should have seen a reverse of the three conditions above: price moving away from its opening level through the day to the upside; an uptrending VWAP line; and price remaining above VWAP.

By around 9:30 AM CT, however, my short-term moving average of TICK turned below zero. Breadth was still negative in the market, not something we'd expect in a market that had shifted from a down open to a solid uptrend. The market pulled back toward its VWAP line before again marching higher into midday on resumed positive TICK. Breadth remained negative, however, and we again pulled back toward VWAP on negative TICK, before again moving higher.

There was a bullish directional bias to the day from open to close, as we can see from the generally upsloping VWAP line. The entire day, however, traded below the prior day's pivot (average price) level on negative breadth. Moreover, the day could not sustain trade above its VWAP line, oscillating above and below. What that tells us is that we had a relatively weak rally in a downtrending market.

As the earlier VWAP post indicated, VWAP can be thought of as the market's evolving estimate of value. In a weak trending or non-trending market, we will tend to move away from VWAP to probe trader/investor interest. If that interest is lacking, we will tend to gravitate back toward that VWAP value level. In weak trending markets, you want to be fading moves away from VWAP.

Conversely, in a strong trending market, we will see strong or weak breadth becoming more extreme through the day. Price will stay above or below VWAP; there will be a positive or negative slope to a Cumulative TICK line (not oscillation of a TICK moving average above and below zero); and the VWAP line itself will sustain an upward or downward slope. Those are the markets where you want to ride moves higher or lower to R1, R2, R3/S1,S2,S3 price targets.

What is the character of the day you're trading? Where we trade relative to the market open and relative to the day's VWAP will provide important clues. At the very least, it will keep you from assuming trends in weak markets and keep you from fading trending ones.