Here’s a step-by-step breakdown of how VWAP works:​

1. Understand the Purpose of VWAP

• Objective: VWAP helps traders determine the average price of an asset based on both price and volume.
• Why Use VWAP?
  • Benchmark: VWAP acts as a benchmark for institutions to assess whether their trades were executed above or below the average price for the day.
  • Price Fairness: It helps traders identify if they are buying or selling at a fair price relative to the day’s trading activity.
  • Trend Indicator: VWAP can also serve as a trend indicator, helping traders assess the overall market sentiment (bullish or bearish).

2. Collect the Required Data

• Objective: Gather price and volume data for each trade during the trading session.
• Required Data:
  • Price: The price at which each trade occurs.
  • Volume: The number of shares/contracts traded in each transaction.
  • Time Period: VWAP is usually calculated for one trading session, but it can be computed for smaller intervals, such as every minute or hour.
• Charting Tools: Most trading platforms automatically calculate and plot VWAP on intraday charts, but understanding the calculation can be useful.

3. Calculate the Typical Price

• Objective: Find the average price for each time period (e.g., every minute) by computing the typical price.
• Formula for Typical Price:

  Typical Price (TP) = (High Price + Low Price + Closing Price ) / 3​

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  • High Price: The highest price the asset traded in that time interval.
  • Low Price: The lowest price the asset traded in that time interval.
  • Closing Price: The price at which the asset closed at the end of the interval.

4. Multiply the Typical Price by the Volume

• Objective: Weight the typical price by the trading volume during each time period.
• Calculation:
  • For each interval, multiply the typical price by the volume traded during that interval:

TP Volume = Typical Price × Volume

• $$\text{TP Volume}=\text{Typical Price}\times \text{Volume}$$ This step gives the price-weighted by the trading volume, which accounts for the significance of heavily traded periods.

5. Cumulative Totals for Price-Volume and Volume

• Objective: Sum up the weighted typical price and the volume over time.
• Cumulative Price-Volume:
  • Keep a running total of the price-volume product for each time period.
  • For each interval, add the TP Volume of that interval to the previous total.

$$\text{Cumulative Price-Volume} = \sum (\text{Typical Price} \times \text{Volume})$$

• $$\text{Cumulative Price-Volume}=\sum (\text{Typical Price}\times \text{Volume})$$
• Cumulative Volume:
  • Similarly, keep a running total of the trading volume:

$$\text{Cumulative Volume} = \sum (\text{Volume})$$

• $$\text{Cumulative Volume}=\sum (\text{Volume})$$

6. Calculate VWAP

• Objective: Divide the cumulative price-volume total by the cumulative volume to get the VWAP.
• VWAP Formula: $$\text{VWAP} = \frac{\text{Cumulative Price-Volume}}{\text{Cumulative Volume}}$$VWAP=Cumulative VolumeCumulative Price-Volume​
• This gives the volume-weighted average price up to that point in the trading session.
• As the day progresses, VWAP continuously updates, providing a real-time benchmark of the average price at which the asset has traded.

7. Plot the VWAP on a Chart

• Objective: Visualize the VWAP line on the price chart to use it as a trading indicator.
• Why Plot It?
  • The VWAP line shows how the stock's price has behaved in relation to its volume over the day. Traders can easily see if the current price is above or below the VWAP.
• Interpretation:
  • Price Above VWAP: The stock is trading at a higher price than the volume-weighted average price, indicating a potential bullish trend.
  • Price Below VWAP: The stock is trading at a lower price than the VWAP, suggesting a potential bearish trend.

8. Use VWAP for Trading Decisions

• Objective: Use VWAP to inform buying and selling decisions.
• Common Trading Strategies with VWAP:
  • Institutional Benchmark: Large institutional traders aim to buy below VWAP and sell above VWAP to minimize their market impact and execute trades at favorable prices.
  • Trend Confirmation: Day traders may use VWAP to confirm the direction of the trend. For example:
    • Bullish Signals: If the price consistently stays above VWAP, it could indicate upward momentum. Traders may use this as a signal to enter long positions.
    • Bearish Signals: If the price remains below VWAP, it could suggest a downtrend, leading to potential short-selling opportunities.
  • Reversion to VWAP: Some traders use the VWAP as a point of price reversion. If the price deviates too far from VWAP, they might expect the price to move back toward the VWAP (mean reversion).

9. Combine VWAP with Other Indicators

• Objective: Enhance trading strategies by using VWAP in conjunction with other technical indicators.
• Why Combine?
  • VWAP is more effective when used with other indicators like moving averages, RSI (Relative Strength Index), or Bollinger Bands to validate trends and potential reversals.
• Example Strategy:
  • If the stock price is below VWAP but oversold according to the RSI, it could signal a potential buying opportunity if the price moves back toward VWAP.

10. Use VWAP for Trade Execution

• Objective: Improve trade execution by using VWAP as a guide.
• Execution Strategy:
  • Traders often compareTP Volume = Typical Price × Volume their executed price to the VWAP to determine the quality of their trade. For example, if a buy order is executed below VWAP, it is considered a favorable trade.
  • Limit Orders: Traders may set limit orders near the VWAP to ensure they enter or exit trades at a fair price.