One of the most commonly used indicators amongst retail and professional traders, alike, is the VWAP (Volume Weighted Average Price). The reason that VWAP is so widely used is because it merges the two most important factors in technical analysis: Price and volume.
VWAP is calculated by taking the average price on a candle, multiplying that value by the volume on the candle, and then finally dividing that value by total volume.
If institutions are looking to buy shares of a stock on any given day, they’re going to be trying to beat VWAP. What that means is, they’re going to be trying to buy the stock at a price that’s lower than what the average price paid for the stock was on that particular day.
The first thing that many traders learn about VWAP is that it is a trend/sentiment tool. If price is above it, then it’s bullish. If price is below, it’s bearish. This belief makes a lot of sense, but does it really work?
To test some of these theories, we decided to use $AAPL as our case study. In the first part of this blog, we test how price reacts when it crosses up or down the VWAP. In our initial testing, we kept the parameters simple:
For a long entry: We enter into a trade when price closes above the VWAP and we sell when price closes below it.
For a short entry: We enter into a trade when price closes below the VWAP and sell when price closes above it.
We tested this strategy on the 1m, 5m, and 15m time frames. We chose these time frames because they’re commonly used by day traders and VWAP resets each day. Finally, our look back period was 7,000 candles.
We’ll spare the nitty gritty details and jump right into the results. They were as follows:
As we can see in the table above, the best performer of these strategies is the long bias trade on the 15m time frame. This makes a lot of sense, of course, because of $AAPL’s consistent strength over the longer term.
Of note, as well, is the asset performance over the same period of time. The 15m time frame was the only time frame in which we did not beat the asset performance over the same period of time. We did so on the other two time frames, regardless of whether it was a short or long biased trade.
A final piece of this data that’s important to note is the win rate, which, as you can see, is abysmal in every test. This is a matter of interest and something to absolutely take into consideration if you’re planning to trade based on these conditions.
Further Study Into Mean Reversion
Now, let’s dig into this idea further and think a little bit more deeply about how to better use the VWAP indicator. Since we know that institutions prefer to try and beat the VWAP, wouldn’t it make more sense to be going long when price is below it and short when price is above it?
This idea takes us to the next set of tests, which bring into focus the concept of mean reversion. Mean reversion is defined as ‘a financial term for the assumption that an asset’s price will tend to converge to the average price over time.
If VWAP represents the average price paid over the course of the day, then mean reversion suggests that price wants to get back to that level if it gets extended in either direction. With that in mind, for our next set of tests, we take an alternative approach to our first test.
Bullish Case Study
For a long entry: We buy when price is below VWAP and sell when it returns back to VWAP (Greater than or equal to).
To test this theory in a number of different ways, we’ve chosen a few different entry points. They are as follows:
- Enter when price is < .10% away from VWAP
- Enter when price is < .25% away from VWAP
- Enter when price is< .50% away from VWAP
To gain an understanding of how to input this criteria into the strategy tester, below, you’ll see an image of the conditions. In the image, we’ve defined our entry as price closing less than the VWAP by at least .10%. In order to access the ‘by at least’ functionality, just click the small box containing three vertical dots. You can change the % value to .1, .25, .50 or whatever you’d like to test. On the exit side, you can see we’ve defined the condition as price closing greater than or equal to the VWAP. Finally, at the top of the strategy tester you’ll see a time frame drop down menu as well as a ‘Data’ drop down menu. ‘Data’ allows you to choose how far back you’d like to test and you can test back up to 7,000 candles on any time frame.
Again, we’ll spare you the details and just cut straight to the raw data. The table below shows a breakdown of the Bullish biased strategy. Remember, in this strategy, we’re buying when price is X% below VWAP and selling when it returns back to VWAP (Greater than or equal to).
What Did We Learn?
At the surface, these results don’t seem all that interesting. There are really no ‘stand-out’ strategies, but the .25% closing distance does seem to offer the best results of the bunch and it performs best on the 15m time frame.
Much like in the first test, the results on the 1m and 5m charts do beat the asset over the same period of time, but the 15m results fall short in every case.
It must be noted, however, that the 5m strategy here does, in fact, outperform the 5m bullish strategy from our first test. This suggests that there is a case for a better way of utilizing the VWAP than just buying when price is above it and selling when price is below it.
A final interesting thing to note here is the win rate, which is quite strong across all distances and time frames.
Bearish Case Study
Now, let’s look at the bearish side of things. For this set of tests, we took the equal and opposite trades as we took for the bullish set:
For a short entry: We buy (go short) when price is greater than VWAP and sell (cover) when price returns back to VWAP (Less than or equal to). In order to utilize the strategy tester in this case, we’ll need to define a few criteria.
Here’s a quick example of how this could be scripted in the strategy tester. In this example, we’re defining our entry as price closing greater than the VWAP by at least .25% and our exit as price closing less than or equal to the VWAP.
Now that we understand how to script this idea in the strategy tester, let’s have a look at the data that we got back from our tests:
Much like the bullish data set, at the surface these returns aren’t eye-popping, but again, we see some interesting areas of strength in comparison to simply going short when price is below VWAP.
What Did We Learn?
First, when we take a close look at the returns of these strategies, we see the most favorable strategy is to go short when price is only .1% above VWAP. The strongest performer at this distance is 1m time frame, which yields us a net return of +2.93%. In fact, regardless of distance from the VWAP, the 1m time frame beats all of the results from our first test.
At the very least, this is interesting to see. Clearly, it’s been better to sell into strength recently, but being that this strategy utilizes the 1m time frame, it does suggest that it’s best suited for an active trader.
Another important note is that it appears that the more extended price gets away from VWAP, the more likely it is to continue in the same direction. This idea is obviously counter to our initial idea that price likes to revert to the mean, and should be taken into further consideration when considering your trade.
Conclusions and Actionable Setups To Try
Our biggest takeaway from this set of tests is that, at least in this case, there is some validity found in our alternative VWAP strategy. Though the results are marginal, a few percentage points in the best case, this could mean the difference between a positive or negative return for an active trader, so the concept here should be considered and explored more deeply if you do utilize the VWAP in your personal trading. For some additional color on the topic, we spent some time and tested a few other alternative strategies to the ones that we focused on. In the two examples below, we make some suggestions for how to expand on the ideas presented above.
- Try adding additional confirming indicators for your entry. For instance, try going short when price is above the VWAP and RSI is at or near overbought levels or long when price is below VWAP and RSI is at or near oversold levels. In the example pictured below, we go short on the 5m time frame when price is above the VWAP by .50% and RSI is greater than 80. The results here beat the same test without the RSI condition by 4%.
- Another alternative to try would be letting the price get farther away from the VWAP, which in theory would increase the likelihood of a reversion back to the mean. In the example below, we use the 5m time frame and enter if price is at least 1.5% below the VWAP. We’re looking to play a very quick bounce here, so we exit 1 candle later and we get a return of 3.52% over the time period tested. This beats all of the 5m bullish strategies that we tested above.
As you can see, the strategy tester can be a wildly powerful tool. Having the ability to test and see what conditions work and what conditions don’t can be extremely beneficial for anyone who is involved in the markets. Whether you’re a day trader or a long term investor, testing out your strategies ahead of placing trades is one of the best ways to get an edge in the markets.
If you’re interested in learning more about the strategy tester, visit this link or take a few minutes and give the below video a spin. It walks through all of the different tools found in the strategy tester and how to use them!
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