Tuesday, February 03, 2009

VWAP, Trends, and Consolidations: A Longer Timeframe Look

This morning's blog post took a look at volume-weighted average price (VWAP) as one way of assessing the structure of the trading day. VWAP offers a nice view of market trending, as directional moves that pick up volume move volume-weighted price significantly.

The identification of whether we are in a consolidating environment or a trending one is crucial to traders and investors alike. We can think of any price series as composed of a linear, directional component and an oscillating, cyclical component. A market with no trend whatsoever would oscillate around a fixed price; a VWAP line would be relatively flat (zero slope) and VWAP would be roughly equivalent to the market's opening price.

A perfectly trending environment would show relatively little oscillation around a upward sloping or downward sloping VWAP line: the linear component would be dominant.

Between these two, we can have relatively weak trends in which there is a directional bent to VWAP, but also considerable oscillation around that level. There is not a "goodness of fit" to a trendline in a weak trend: the move proceeds in fits and starts with considerable backtracking on moves.

To the degree we are in a consolidating environment, we want to be fading moves away from the VWAP line. In a weak trend, we fade moves toward or below VWAP and enter in direction of the line. In a strong trend, we will tend to stay above VWAP and, instead, will use shorter-term pullbacks (bounces or dips in NYSE TICK, for example) to ride the directional move.

These ideas regarding market structure and trading strategy apply to multiple time frames. Above is a daily chart of the S&P 500 Index (SPY) and its 20-day VWAP line (green). Several readers have asked about computing/charting VWAP; e-Signal offers it as a moving average option. (My VWAP charts from previous posts were constructed in Excel). By adjusting the lookback period, you can plot a VWAP moving average and see how we are trading relative to that estimate of market value.

Note in the chart above that the VWAP line on the longer time frame has been moving steadily lower. Since October, we have been oscillating above and below the VWAP line in a consolidating market. We can see, however, that the forays above VWAP have occurred at successively lower price highs (blue arrows). This mirrors Monday's observation from the Cumulative DSI. With a downsloping VWAP, we have a weak downtrend and moves to/above the line become candidates for selling. To achieve uptrend mode, we need to sustain trade above VWAP and see a rising VWAP line; the market is not giving us that yet.