Volume-Weighted Average Price (VWAP) is a trading algorithm based on a pre-computed schedule to execute a large order to minimize any impact on the market price.
Let’s say you want to buy 15 million shares of Apple (or 1000 BTC) which is almost half its average daily volume. You can’t buy them all at once because this would impact the market and cause the price to rise.
What you need to do is to split the order into small pieces and execute them without impacting the market. Doing this manually would be ludicrous, and that’s where an execution algo like VWAP comes in.
VWAP is also thought of as a measure of the average price at which an asset is traded over a given period of time.
To calculate VWAP, you use the following equation:
VWAP = ∑(amount of asset bought x asset price)/total shares bought that day.
The standard VWAP is calculated using all of the orders of a given trading day, but it can also be used to look at multiple time frames. The VWAP ratio is then presented on a chart as a line.
It has been likened to a moving average, in that when the price is above the VWAP line the market is seen as in an uptrend, and when the price is below the VWAP the market is in a downtrend.
How Institutaions Use VWAP
Many large institutions will use the intraday VWAP (volume-weighted average price) as a fair value point from which they will continue campaigns of accumulation or distribution
This means that if the price is below VWAP and they have an urgent order to buy a certain number of millions of shares in a certain number of days, they would want to buy below VWAP.
But if they fall behind enough on their accumulation campaigns, they might start buying a bit above VWAP to show their hand, or if many do this, they compete for the same VWAP bid.
Many day traders know this and like to make bullish momentum trades when the price diverges above VWAP (or vice versa with bearish trades if it is diverging below VWAP).
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