VWAP Trading Strategy: Calculation Methods and Trading Signals

Intro

The Volume-Weighted Average Price has gained a special place in the realm of technical indicators. It is a tool suitable for methodic traders who seek more beneficial forecasts without the need to face noisy signals. In a market condition like the one offered by cryptocurrencies, carrying only VWAP signals may not be the best approach. 

However, there are other ways to choose and boost the effectiveness of VWAP performance. In this article, we will discuss some of the most relevant aspects of this and how to overcome crypto market conditions with it.

Deciphering what is the Volume-Weighted Average Price?

Cryptocurrency trading is an activity known for its volatility, leading to notable price changes in the short term. Technical indicators offer a solution to survive those environments, and that is the case of the Volume-Weighted Average Price (VWAP), a technical tool offering a wide spectrum viewpoint for the measurement of the average price at which a crypto asset has been traded during a specific timeframe.

VWAP adds weight to both the price and volume of each trade. It essentially spots out the average price at which a certain amount of a crypto asset was bought and sold within a given period.

An increased VWAP proximate to the current price suggests buyers were dominant, potentially moving the price up. Conversely, a low VWAP indicates sellers were in control, potentially moving the price down.

Calculating VWAP: Behind the formula

VWAP is, after all, a sophisticated tool that lies on a mathematical formula calculating the sum of prices multiplied by the volume of each trade.

Let's try to break down it:

• VWAP = (Σ (Price × Volume)) / (Σ Volume)

Where:

• Σ represents the summation of all trades within the chosen timeframe (typically a day).
• Price is the quotation of each individual trade.
• Volume is the magnitude of each individual trade.

Trading Cryptos with Volume-Weighted Average Price

For crypto trading, as remarked previously, the inherent volatility is a special consideration to carry. The sophisticated calculation of the VWAP does not come alone but with a step back in its application: VWAP carries with lagging nature and can generate false signals in highly volatile markets. 

The speedy change of prices may be so fast that VWAP is not able to react accurately to the current market sentiment.

So what would be a proper way of using VWAP for crypto trading?

Identifying Trends

A price quoting consistently above VWAP suggests a possible uptrend with strong buying pressure.

The opposite scenario, when the price is consistently below VWAP, suggests a potential downtrend with selling power.

Spotting Potential Reversals

If the price comes closer to VWAP from either direction, it might signal a consolidation phase or a trend reversal. This is especially accurate after a strong directional move.

Support and Resistance

VWAP can act as Dynamic Levels, across dynamic support or resistance representing relevant supply and demand zones. During a downtrend, the price could face momentary support at the VWAP before bouncing back up. Conversely, during an uptrend, the price may face resistance at the VWAP before potentially breaking through.

Trading Strategies: Exploring the VWAP Possibilities

VWAP can be the right choice for those traders looking to craft a strategy with a very methodical approach and specific forecasts. The lagging characteristic of this indicator may not offer much versatility compared to others more responsive but stands out in other scenarios.

Let's try to outline stand out some common strategies:

Mean Reversion Strategy

This strategy is simple and states the following:

1. Buying when the price plunges below the VWAP, expecting a bounce back towards the VWAP (average price).
2. Selling when the price waves above the VWAP, anticipating a pullback towards the VWAP.

Breakout Trading Strategy

VWAP breakout can help across consolidation phases in the market, let's see:

1. VWAP suggests entering long if the price breaks through and closes consistently above the VWAP, implying a potential continuation of the uptrend.
2. VWAP suggests entering short if the price breaks out and closes consistently below the VWAP, implying a potential continuation of the downtrend.

Confirmation: Making duos with other indicators

VWAP can offer reliable signals for very specific cases at the cost of its lagging nature, other indicators can help to confirm signals in fast-paced environments.

Let's discuss some interesting combinations of VWAP:

• VWAP with Exponential Moving Averages (EMA): EMAs smooth out the price fluctuations, bringing out the underlying trend with high responsiveness. Combining VWAP with EMA strategies like the "trio" of 20-day, 50-day, and 200-day periods can provide a more strong confirmation of the trend direction. For example, in an uptrend, while the price is trading above the VWAP and the EMAs are binding upwards, it strengthens the uptrend signal. Conversely, if the price is below the VWAP and the EMA is binding down, it reinforces the downtrend.
• VWAP with Relative Strength Index (RSI): RSI gauges price momentum and identifies overbought or oversold conditions. Divergences between VWAP and RSI could spot price reversals. In the same way, if the price makes new highs but the RSI fails to follow, we spot a bearish divergence. On the opposite, a bullish divergence can suggest an upside continuation despite a price pullback.
• VWAP with Bollinger Bands (BB): Bollinger Bands is the perfect choice for measuring price volatility. Through band contraction and widening, it indicates volatility levels and anticipates potential breakouts. If the price is trading near the upper band and above the VWAP, it suggests strong buying pressure. Conversely, a price trading near the lower band and below the VWAP suggests strong selling pressure

Risks and Management: Common Pitfalls to Consider

As with any other indicator, traders must be aware of:

1. Volatility.
2. False signals,
3. Market context and structure.
4. Backtesting to refine strategies.
5. Crafting trading plans

Conclusion and call to action

The Volume-Weighted Average Price is by far a useful tool for technical analysis. Although it may not be so flexible, it can be combined with other tools and provide a broader viewpoint of the market conditions.

In Altrady you can continue learning more about other indicators suitable for VWAP and start testing the discussed strategies with a FREE trial account on paper trading. Don't miss this chance.