Volume Indicator MasterClass — Part 3

Published in

Mudrex

7 min readJun 19, 2020

Volume Weighted Average Price

In the last couple of articles we talked about the various use cases of traded volume and the implementation of one of the most popular volume indicators, OBV (On Balance Volume), on Mudrex. Checkout the last article if you haven’t already. In this article, we will be talking about the different interpretations of another popular volume indicator, the Volume Weighted Average Price, and how to make your own auto-trading bot using the same on Mudrex. We will be covering the following details in-depth with descriptions on charts and on Mudrex Strategy Canvas wherever necessary:

Introduction to VWAP
VWAP Formula & Calculation
Institutional Investor Usage of VWAP
Strategy Description
Mudrex Auto-Trading Bot

Introduction

Volume Weighted Price Average (VWAP) is an indicator used by institutional traders to help determine a price range where they want to place their bulk trades. As the name indicates, it is based on the average trading price weighted by volume of trades for the current day. This indicator can also be used by non-institutional traders as an odds enhancer for investing and trading. It is a trading benchmark used by traders that gives the average price a security has traded at throughout the day, based on both volume and price.

It is an intraday trading volume indicator whose calculation starts when the market opens and ends when the market closes. It is basically a moving average with more weightage given to the candlestick prices with higher traded volumes than those with lower traded volumes.

Calculation

Calculation of VWAP is a 3 step process. It is a volume-weighted average of typical prices.

Typical price for the intraday period is the average of the high, low, and close of each candlestick: {(H+L+C)/3)}
Each typical price is then multiplied by the traded volume of that candlestick.
Sum of this volume-weighted typical price is then divided by the total volume traded till now:

The VWAP values are then plotted as a cumulative line graph over the candlestick chart, and useful insights can be drawn from whether the prices are closing above the VWAP line or below. General interpretation is that, buy for prices above VWAP and sell for prices below VWAP.

Institutional Usage

When institutions look to buy or sell in the financial markets, they are typically doing it in a large quantity. In order to not disturb the delicate balance between demand and supply, they must break their orders into smaller pieces so they can buy and sell unnoticed. This action is called, working the order. Volume weighted average price (VWAP) is the indicator the institution uses to make sure they are getting a good average price for their security.

Let’s imagine that an institution wanted to purchase a million units of particular cryptocurrency. If they were to place the order for the full number of shares, the market would see the huge demand created by the buy order and prices would likely jump up very rapidly as there are not enough sellers to satisfy the order. Also, since there are rarely any orders placed larger than a few hundred units, if an institution were to place such a large order, it would attract unwanted attention and the sellers would retreat to higher prices.

Other buyers would wonder why someone wanted to buy so much crypto and they would likely front-run the large order. Front-running is where orders are placed at a slightly higher price than the previous ones to get filled first. Orders are filled on a first come, first served basis and based on price. The best price gets the trade. If an institution placed a large order, they would likely not get their order filled as others would front-run them and drive prices higher.

So, to get a large position filled in any security, the institutions will identify a price range where they are willing to enter and then work their order by placing a series of small orders within that price range. Should prices leave the range, the institution will simply wait until it returns, to complete their position.

This is where VWAP comes into play. When an institution is looking to purchase a large number of shares they will attempt to buy them at a price below the VWAP. Since the price is lower than VWAP while the volume of the trade is very high, the institutional trade would push the market price to the average range rather than disrupting it away from the average. A similar process applies when they want to sell shares, they will try to sell at prices above VWAP.

Strategy Description

However logical and interesting the above approach might seem, it doesn’t do much good to a retail trader. Retail traders perform very small day-to-day trades which aren’t capable of disrupting the overall trend of the market. So the only useful insight small traders can withdraw from VWAP is whether his/her order is above/below the average market price.

One thing which you might have realised by now is that the crypto market is open 24×7 whereas VWAP is an intraday indicator whose calculation starts when the market opens and cumulatively ends when the market closes. Well, Mudrex has your back on this. The VWAP indicator block on Mudrex has a “look-back period” parameter which can be used to set the period for which you want the weighted mean for VWAP to be calculated.

Crossovers of VWAP can be used exactly like crossovers of SMA/EMA work. Look-back period of VWAP can be easily set on Mudrex. MVWAP with a shorter look-back period will closely follow the recent price whereas VWAP with a longer look-back period indicates the overall trend of the market. Hence, when shorter-VWAP crosses up longer-VWAP, it means that the recent prices are rising and an uptrend can be anticipated. On the other hand, when shorter-VWAP crosses down longer-VWAP, it means that the recent prices are falling and a downtrend can be anticipated.

The standard look-back periods of MACD are 12 and 26. Using the same for shorter and longer VWAP we get the following buy and sell conditions:

Buy when: 12-VWAP crosses up 26-VWAP
Sell when: 12-VWAP crosses down 26-VWAP

Building on Mudrex

Compare block for the buy condition of 12-VWAP crossing up 26-VWAP looks like this:

Compare block for the sell condition of 12-VWAP crossing down 26-VWAP looks like this:

Overall strategy looks somewhat like this:

And we’re done! This is how easy it is to create your own auto-trading bot on Mudrex without minutes. We used the standard look-back periods of MACD for experimental purposes only. You can use your own parameters and check the strategy performance on Mudrex.

Backtest results for the current parameters shows that the strategy does not perform very well in choppy markets due to too many false crossovers of long and short period VWAP. This can be prevented by increasing the length of the shorter look-back period or by using a stop-loss to prevent any downsides of false signals.

In a trending market though, the strategy gives amazing returns by buying low and selling high. This is due to the fact that unlike price indicators, volume indicators consider both the important factors of trading, price as well as volume.

Two consecutive winning trades at the crossovers of VWAP

This is how effective VWAP can prove out for retail investors in trending markets. Just like EMA/SMA, a lot of other strategies can be made using VWAP in combination with other price indicators. In the next article on our Volume MasterClass, we will talk about another very common volume indicator called the Money Flow Index, which closely resembles RSI.

Stay tuned!