How to Use a VWAP Indicator & Strategies to Day Trade Crypto
As a technical analysis tool, Volume Weighted Average Price (VWAP) is suitable for day traders and intraday traders in general, mostly due to its accuracy to spot exit-entry points in a short-term timeframe. Since cryptocurrencies are prone to violent price swings and the crypto market operates 24 hours per day, traders are constantly looking for ways to capitalize on the opportunities. VWAP trading helps traders identify when they should buy or sell. Therefore, many day traders build their crypto strategies around it.
What Is Volume Weighted Average Price (VWAP)?
Volume Weighted Average Price (VWAP) is a tool used by day traders to weigh price against volume traded in order to determine if a market trend is overbought or oversold. The VWAP helps traders time their entries and exits in stock and crypto markets.
When interpreted correctly, it can help a trader find good entries into the market, based on its relative value to trades that have been previously placed. Additionally, traders can see when the price action of an asset has gone too far too fast and may consider exiting their positions.
How to Use VWAP to Spot Upcoming Market Trends
To learn how the VWAP tool works, it’s important to understand how the calculation is made.
First, the VWAP line resets each trading day. Since this tool was created for day traders, it’s important to have the calculations reset at the beginning of each day.
In the Bitcoin chart above, the blue line is the VWAP line. Each vertical black line is the start of a new trading day. Just after the trading day starts near the black line, the blue line slopes sharply. This is due to the VWAP calculation resetting.
Here is the calculation for the typical price, which is an average of the high, low, and close prices for the candle time frame.
Typical Price = (High + Low + Close) / 3
Most charts and indicators are based on the closing price of the candle. So by default, an indicator running on a 15-minute chart will run its calculations from the closing price of each 15-minute candle. For VWAP, the default takes an average of that candle’s high, low and close, arriving at a true price for that period. This is useful when the market reverses, allowing the trader to understand the current and future trends.
Using the Typical Price to Create the VWAP Line
Once the typical price has been created, it’s multiplied by the volume traded during that time frame:
Current Time Frame Subtotal = Typical Price * Volume (written as TP*V)
If you’re using 15-minute candlestick charts, the trading volume generated for those 15 minutes is multiplied by the typical price to arrive at the subtotal.
Then, each subsequent 15-minute calculation gets added to the subtotal for the trading day, creating a cumulative TP*V value.
The final part of the calculation creates a ratio of the cumulative TP*V to the cumulative volume:
VWAP = Cumulative [TP * V] / Cumulative Volume
The result of this calculation is a line that maneuvers through the price chart, generally in line with the crypto price.
Fortunately, you don’t have to do these calculations yourself. The computer charting software will calculate for you and plot it on your price chart.
Using VWAP to Identify Overbought and Oversold Levels
The VWAP provides average pricing based on the amount of trading volume for that pricing level. Therefore, you can view the VWAP line as a true average price.
If the price is above the VWAP line, then it is considered expensive and overbought. You can buy the market in the overbought zone, but you would be paying more for it.
On the other hand, below the VWAP line suggests the market is underpriced, and perhaps a good buying opportunity. This doesn’t prevent the market from getting cheaper, but it’s a relatively better value than buying when it’s expensive.
Which Chart Is Most Useful for Spotting Trends with VWAP?
VWAP is a day trader tool. Therefore, if you like to day trade crypto and hold your trades for less than a day, VWAP is a good tool to use.
Crypto day traders are likely to use minute charts, such as 1-, 3-, 5- or 15-minute. These smaller time frame charts using VWAP allow the day trader to visualize how the average price is based on the amount of volume being traded.
As volume is an important part of the calculation, markets traded on exchanges (such as crypto and stock markets) are prime candidates for using VWAP. Forex is traded over the counter, and therefore, volume figures, if provided, may not be accurate. In this case, the VWAP indicator may generate false signals.
Volume Weighted Average Price Day Trading Strategies
There are a few different ways to find trading opportunities using VWAP. Before we dive into them, it’s important to note that changing market conditions can have both positive and negative effects on these strategies.
For example, day trading (short-term traders) usually trade 24 hours per day and 7 days a week, including weekends. VWAP will still calculate over the weekend, but it may not be the most suitable time to trade, as any large trade can push the market significantly in one direction or the other.
Therefore, consider these trading strategies from Monday through Friday, which is when the most volume is produced in crypto.
Trading Strategy 1: The Retracement Trade
This first strategy is considered more conservative as we let the market do the heavy lifting for us. The tools needed include a 15-minute price chart for main crypto markets like Bitcoin or Ethereum, plus the VWAP indicator.
First, if the crypto markets are in an uptrend, bias your trades so that you’re only looking for long positions.
Wait for the crypto market to dip and close below the VWAP. This will cause an open alert that a buy signal may be coming soon.
Then, wait for the candle to close back above the VWAP indicator. Once the candle has closed above the VWAP, enter long on the open of the next candle.
Set your stop loss just below the recent swing low. That way, if the price corrects back below the recent low, it will have to correct back through the VWAP.
In the Bitcoin chart above, the distance between the entry and the stop loss is 410 Bitcoin points. We’ll set the profit target to at least twice the distance between the entry price and the stop loss. In the example above, we’ll target $410 x 2 = $820. Therefore, we add $820 to our entry price of $32,129.50 and set a profit target level of $32,949.50.
Trading Strategy 2: VWAP Bands and Channels
This second strategy is a little more aggressive because it calls for a day trader to enter at better and lower prices, which can mean entering into an increased number of losing trades.
Open your chart to a 5-minute candlestick setting with VWAP included. For this strategy, we’re going to add an extra tool. Activate the bands around the VWAP to two standard deviations.
This will add an upper and lower boundary to the VWAP line. If the crypto markets are in an uptrend, only look for buy signals.
Wait for the market to dip down to the lower band. Sometimes, the price will shoot outside of the band. If that happens, wait for the price to return above the band, placing it inside the channel.
Next, initiate a long position with the risk set to below a recent swing low on the chart. Just as with the previous strategy, set your profit target to a length of twice the distance between the entry and the stop loss.
In the Ethereum chart above, the price drops below the lower band, then rebounds higher a couple of candles later. Once Ethereum rebounds inside the green channel, it triggers a buy signal. The risk and stop-loss are set to a recent swing low from earlier in the week.
Ethereum eventually rallies, reaching the profit target.
VWAP vs. Moving VWAP: The Differences
As we’ve noted above, VWAP resets its calculation every day in order to be useful for day traders. However, there are times when traders might want to see the overall weighted trend of pricing. This is where the moving VWAP (MVWAP) comes into play.
The moving VWAP is just that: a moving average of the VWAP. Though these two indicators share the same VWAP, there are some big differences between them.
First, VWAP is developed for shorter-term day traders. Moving VWAP can be used on longer-term chart time frames, spanning days, weeks, or even months.
Secondly, VWAP provides a running total throughout the day and ends at the day’s close. The VWAP calculation will start fresh every day at that day’s open. Moving VWAP provides an average based on your selected range. This means the calculation continues indefinitely and is carried over day by day.
The last difference is in how the indicators are used. VWAP indicates overbought and oversold readings based on volume. On the other hand, MVWAP can be used as a moving average crossover strategy.
Technical Indicators to Use with Volume Weighted Average Price
The basis of the VWAP indicator is to determine when the price may be relatively cheap or expensive. However, using the indicator by itself can lead to inaccurate signals. There are a couple of other indicators which complement VWAP quite well in identifying trading opportunities.
Pivot points were used by floor traders back when trading was conducted in trading pits — before computers. The traders needed a quick calculation that they could complete in their heads to determine potential reversal points in the market.
Therefore, daily pivot points are important to a day trader because they are price-driven levels, signaling where a market may pivot and reverse.
In the image above, the black horizontal line is the pivot point. The orange horizontal lines are the various pivot levels. When the market is below the black line, the orange support pivot levels may support prices.
This is especially useful when a day trader is seeking out long entries, with the market below the VWAP. The crypto day trader can wait for the price to reach S1, S2, or S3 to initiate a long position.
The time frame for the chart above, showing S2 support prices, is two days.
VWAP and Trend Lines
Other technical tools generating support and resistance levels are useful when combined with VWAP. For example, trend lines are helpful for traders determining trend direction over multiple days. Additionally, trend lines can identify when the trend may pivot and reverse.
On the chart above, a day trader with a multi-day trend line on the chart can identify areas where price may reverse. At the spots where the trend line is touched, the price is below the VWAP indicator, suggesting a good value and cheap price.
Is Volume Weighted Average Price (VWAP) Reliable?
Day trading is inherently risky and VWAP is a tool to help bring more consistency to the trader. However, there are instances where VWAP will likely produce false signals due to the market noise, so it’s important to understand these situations.
VWAP uses volume in its calculation. Therefore, when the market is experiencing prolonged days with weak volume, there is likely to be a range-bound sideways trading environment. As a result, the signals VWAP gives may not be reliable.
In addition, although signals from the VWAP may be reliable much of the time, the costs of making frequent trades will eat into profits. With each open position, there is a spread cost that is taken by the trader. After you open the position, you cannot close it immediately for a profit, as the market makers are going to take a spread for offering the trade to you.
The Bottom Line
Volume weighted average price is a crypto day trader’s friend because it helps determine the average weighted price. Many crypto trading strategies can be built around VWAP, using other tools like channel bands, pivot points, and other support and resistance levels. However, VWAP can be prone to false signals if it’s used in the wrong market environment.