Sunday, November 16, 2008

Trending Markets and the Volume Weighted Average Price (VWAP)

Brian Shannon has nicely described how the volume-weighted average price (VWAP) serves as an institutional measure of value for the trading day. VWAP builds during the day, with price weighted by the volume traded at that price. As a result, an uptrending market that is attracting volume from buyers will show a smoothly rising VWAP. During such an uptrend, price will remain above VWAP and will build distance above it. Conversely, in a downtrend that is attracting volume from sellers, we will see a steadily falling VWAP. Price will remain below VWAP and will build distance below it.

We can think of VWAP as the market's emerging estimate of value for the trading day. Thus, where we trade relative to VWAP tells us whether we are shifting value to the upside or downside. In the chart above, we can see that crossovers of VWAP told us we were not trending on the day. On range days, we will oscillate above and below VWAP; fading those moves for a return to value becomes a successful trade.

Much of intraday trading consists of recognizing when we are escaping the orbit of value/VWAP to the upside or downside and when we are bound to its gravitational pull.