Wednesday, June 11, 2008

The VWAP--Volume Weighted Average Price

I'm in the middle of my stop/loss research that I began a couple of weeks ago, before my software program crumped out and a trip back to my homeland forced me to table it. But instead of neglecting today's blog, I thought I'd introduce the concept of the VWAP. No, this isn't a type of gourmet sandwich or new German automobile. It's an acronym that stands for volume-weighted average price. I know it sounds like a mouthful, but the VWAP is a useful tool that traders and investors can add to their trading arsenal.

What is the VWAP?
The VWAP for a particular stock is a simple mathematical formula computed by adding up the dollars traded for every transaction (price times the number of shares traded) and then dividing by the total number of shares traded in that time period (usually in a day). VWAPs are mostly used by institutions and pension funds which is why the typical retail investor (i.e., you) probably isn't familiar with it. You can find it in some of the more powerful charting programs. I use Qcharts, a subscription-based charting program, and one of its features includes a hot list of 100 stocks that are currently trading at prices above their VWAPS and another list trading below them.

What does the VWAP tell us?
Although the VWAP sounds a bit esoteric, it has some very practical uses. Some traders use it as a pricing indicator. If a stock is trading below its VWAP, then it's considered a bargain and that's when a bullish investor would buy it. (The reverse situation would apply to a short trade.) Others use it as an overall indicator of a stock's direction. For example, stocks trading above their VWAPs are those that people--institutions especially--are buying. This is considered a bullish sign. On the other hand, a stock trading below its VWAP is considered to be bearish, especially if it's been trading below it for some time. These make excellent shorting candidates. Looking at my hotlists right now, I'm seeing Ensco Int'l. (ESV) and James River Coal (JRCC) near the top of the Above VWAP list. The charts of both stocks are making new highs. On the short side, Baidu (BIDU), Intuitive Surgical (ISRG), and Deckers Outdoor (DECK) are heading up the Below VWAP list. Although none of these stocks are even close to hitting new lows, their charts are all in a bearish trend.

The other way I like to use my VWAP lists is to look at the values on each of the list to determine the overall tone of the market. Stocks trading above their VWAPs have VWAP values above zero. A value above +150 or so I consider to be very bullish. Values above +300 indicate extreme over-bought conditions and almost always signal that a market turnaround is imminent. Conversely, stocks trading below their VWAPs have VWAP values less than zero. Through many years of daily observation, I've found that the magnitude of the negative VWAPs are typically not as great as the positive ones, so that values around -100 I consider to be quite bearish and those below -200 to show an extremely oversold market.

To properly deduce market tone, I look at VWAP values in the middle of my hot lists which is the fiftieth stock from the top. This is more representative of the total market since the values at the top of the list are generally quite skewed. Here's a few guidelines that correlate with market tone:
1. If the fiftieth value on the Above VWAP list is much greater in magnitude than the corresponding one on the Below VWAP list, the market is in an uptrend since there is more buying activity. The greater the difference between the two values, the more bullish the market. In highly bullish markets it's not unusual to see a positive VWAP of +150 to +200 and negative VWAPs in the single digits.
2. If the positive VWAP value (the one at the fiftieth position) falls and the corresponding negative VWAP begins to increase (in absolute magnitude terms), the market is changing direction and heading downwards. (Vice versa for the other direction.) This is good to note because this type of shift is sometimes an early indication of changing market winds and can be a useful tool for day traders.

I've been watching the positive and negative VWAPs for over the past hour, just before the market closes and I did see the VWAPs shift from a positive value of +110 and a negative value of -88 to a positive value of +76 and a negative value of -117. This shift corresponded to a six point decline in the S&P.

Many of you may not have access to this indicator but if you do, you now know a few ways to take advantage of it. VWAPs are especially good indicators of market tone that day traders of S&P futures might find to be particularly beneficial. Good luck and good VWAPping!

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