As most traders will discover, there are a huge number of technical indicators out there for almost every style of trading imaginable. It can take a long time to find tools that are most applicable to your own personal trading methodology.
I’m a fan of VWAP bands for determining market direction. They can be a useful indicator for detecting whether a market is trending or ranging. They can also provide interesting entry and exit signals.
The Volume Weighted Average Price (VWAP) has similarities to a moving average, in that it shows how the average market price changes over time. However, VWAP includes a weighting for traded volume, so heavier trading activity has a greater impact on its direction. Low volume periods will move the VWAP less than high volume periods.
The VWAP is important because institutional investors often use it to determine what is ‘fair value’ for the day. They will then try and buy or sell as close to the VWAP as possible in order to get ‘good value’ fills for their clients. You can often see the market reacting when it gets close to the VWAP.
The chart below shows a simple VWAP, plotted in pink, on a 5 minute chart for crude oil (CL). As you can see the market has been bearish for most of the day, and is staying below the VWAP. When the market approaches the VWAP line there was some heavy selling, most likely from institutional investors looking to go short, or exit long positions.
I use VWAP to get an indication of market direction. If the market is bearish, it will tend to stay below VWAP, and vice versa for bullish. In this trending situation I would look for a pullback to then trade with the trend. For example, in the chart above, when the market approached the pink VWAP line at around 15:00, I would go short.
In ranging markets when the direction is sideways, you will see the market fluctuate above and below VWAP (as shown below). In this situation I would fade into entries by buying below, and selling above the VWAP
As can be seen from the above chart, it is a little harder to trade a ranging market with this method than a trending. When the market is moving sideways, it is sometimes difficult to determine just how far from the VWAP the market will move, before returning back above. It is also important to watch out for range breakouts.
Using a mathematical formula to determine standard deviations from the VWAP, it is possible to create additional indicators to help determine market movements. Exactly how you create the VWAP bands will be dependent on your charting package. With Sierra Chart, they plot 0.5, 1, 1.5 and 2 standard deviation bands from the VWAP, as default. See chart below.
I find the 0.5 standard deviation (first band above and below VWAP), and also the 2 standard deviation (the outer bands), as the most useful in terms of trading signals.
As with most technical indicators, it is really a case of repeated practice and learning to see how your chosen market interacts with VWAP. The examples I have chosen here are for crude oil, it may be that other instruments such as the S&P500 have completely different characteristics. It is important to watch and learn for as long as possible, before building a trading strategy.
In figure 3 above, you can see how the market tests the outer VWAP band between 11:00 and 13:00. It then pulls back to the pink VWAP line, and can’t get past the first standard deviation above the VWAP.
From previous experience of watching the crude oil markets, I would know that in a down trend the area around the VWAP (between the first standard deviation bands, shown here in blue), would be an interesting selling area.
Clearly there are no guaranteed rules, and the market can change direction at any time. However, by studying how the markets interact with the VWAP bands, you can begin to discover the price-action characteristics of that market.