In the world of trading, including cryptocurrency trading, people don't solely rely on intuition. They use various technical analysis tools to identify patterns on price charts that indicate potential price changes. These tools are not universal; different trading strategies require different tools, and their accuracy varies.
The Volume Weighted Average Price (VWAP) is a technical analysis tool known for providing precise short-term average price assessment, making it a preferred choice for day and intraday traders. In this article, we will explore the significance of VWAP, recognize its constraints and clarify its calculation process.
- What is Volume-Weighted Average Price (VWAP)?
- How to Calculate VWAP?
- How to Use VWAP?
- VWAP Limitations
What is Volume-Weighted Average Price (VWAP)?
The Volume Weighted Average Price (VWAP) is a trading indicator used to calculate an asset's average daily price. Many traders widely consider VWAP to be one of the most accurate indicators.
The VWAP indicator furnishes a precise average price for a cryptocurrency, enabling swing traders to leverage this value to buy when the price falls below the VWAP marker and sell when it surpasses it.
Image source: FXOpen UK
Generally speaking, the volume-weighted average price is a powerful indicator for short-term trading strategies, signaling whether it's more favorable to buy or sell. Simply put, this indicator aids in determining if an asset is overbought or oversold, facilitating better market entry and exit points. Moreover, VWAP helps to spot if the price is rising or falling too rapidly, enabling timely reactions to these changes.
Additionally, long-term traders sometimes utilize VWAP to compute the average monthly price. Since cryptocurrency markets operate 24/7, the flexibility of the VWAP allows it to be applied across different time frames. Each trader is free to use it according to their unique style. It's essential to note that like any other indicator or pattern, VWAP is most effective when used in combination with other indicators and patterns, helping to avoid potential errors.
How to Calculate VWAP?
Let's jump into how VWAP is calculated, using the BTC/USD pair as an example. In this context, VWAP is expressed in dollars. The formula works as follows: the total sum of dollars exchaged for BTC during a given day is divided by the number of units traded. For instance, if four Bitcoins were sold on a specific day at $30,000, $32,000, and twice at $34,000, the VWAP value for that day would be $32,500.
Image source: Education Center - How the Market Works
The calculations of the volume-weighted average price are updated at the start of the trading cycle, once in 24 hours. You don't have to crunch these numbers yourself, as most exchanges automatically provide the VWAP valuations. Unlike most other indicators, which use the closing price as a reference, VWAP is based on the average of the candle's extremes and its close price. VWAP is closely related to the so-called typical price, which is the sum of the peak, bottom, and closing prices divided by three. This typical price forms the basis for the volume-weighted average price.
The typical price determines the VWAP. The product of the typical price by the traded volume within a given period is known as the current time frame subtotal. For example, if you're using 15-minute-based candlestick charts, then you'd use the peak, bottom, and close prices for this 15-minute period to calculate the typical price. You'd then multiply it by the trading volume associated with this 15-minute period. Next, all the subtotals are added up to create a cumulative total. The VWAP valuation is the ratio between this cumulative total and the cumulative trading volume. The resulting line mimics the price's path on the chart but remains somewhat distanced, as the VWAP is never identical to the price at any given moment.
How to Use VWAP?
VWAP is especially useful for day traders. Charts with 1 to 15-minute time frames effectively display the relationship between trading volume and average price, making VWAP a handy tool for trading strategies that utilize candlestick charts. However, it's worth noting that OTC desks are not suitable for VWAP utilization.
We can name several popular trading strategies centered around the VWAP indicator. It's important to note, though, that adhering strictly to a single strategy isn't as effective as adapting to different strategies based on the current market conditions. Shifting market circumstances necessitate appropriate reactions and corresponding strategy changes.
In the realm of crypto trading, the highest volume is usually reached within business days. As such, the VWAP indicator might provide less accurate data on weekends when substantial trades can swiftly impact market trends. In contrast, the Monday to Friday period is typically more stable.
One popular application of the VWAP indicator is within the retracement trading strategy. This strategy is relatively straightforward and perhaps better suited for risk mitigation rather than maximizing profits. However, it can be an excellent choice for beginners.
The retracement trading strategy with VWAP requires the use of 15-minute period candlestick charts. In an uptrend, you'd use the VWAP to identify a buying opportunity. You should wait until the price drops to or near the VWAP line. When the candle closes above the VWAP level, it's time to place a long position. This should be a stop-loss order set below the most recent minimum. If the price dips below the previous low, your order will be executed successfully, and you'll be able to sell the asset at a higher price soon after the correction finishes.
The VWAP is also applicable to the bands and channels strategy, which is slightly riskier than retracement trading but also offers the chance for larger profits.
For this strategy, it's advisable to switch to a 5-minute candlestick chart. In addition to using the VWAP indicator, you'll need to enhance the VWAP line with bands set to two standard deviations, thereby providing upper and lower border lines.
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In an uptrend, you'll need to wait for a buying signal. At some point, the price will dip below the lower band. It will then return above the lower band but remain below the upper one. At this point, you should place a stop-loss order with the risk set at the mark below the most recent minimum. The profit target should be set at twice the distance between the entry level and the stop loss. As soon as the price spikes again, crossing the lower boundary, it will trigger your order. Once the correction period ends, you're free to sell what you've bought.
No indicator is without its shortcomings. As previously mentioned, the VWAP is best suited to short-term trading. Although it can be applied to longer time frames, the VWAP becomes less accurate over several days. More than that, even within a several-hour frame, its accuracy decreases with time.
There are situations where the uptrend is so strong that there are minimal drops or corrections. In these cases, most strategies centered around the VWAP are not applicable. If you wait for a buying opportunity, you might miss the chance to profit from a more proper strategy.
The VWAP is a potent indicator for short-term trading. While it doesn't inherently possess predictive capabilities, it can provide key insights into the current market situation, allowing traders to optimize their market entry and exit points. This tool can be instrumental for day traders and can be used in various strategies, from simple retracements to band and channel strategies. However, like all indicators, it's not perfect and has its limitations.
For instance, during a sustained uptrend without significant retracements, the VWAP may provide fewer trading opportunities. Furthermore, it's crucial to remember that relying solely on a single indicator can be risky. The best approach is to use VWAP in conjunction with other indicators and tools, tailoring your strategy to align with current market conditions.
Lastly, it's worth noting that the VWAP, like any tool used in trading, requires an understanding of its uses and limitations. It is always recommended to practice using the VWAP in a simulated trading environment before applying it to live trades. Only by combining theory with practice can you truly master this powerful trading tool and make the most out of your cryptocurrency trading activities.