Last Updated on 11 September, 2020 by Samuelsson
Moving averages come in many forms and shape. Just to name a few, you have the simple moving average, the exponential moving average, and VWAP, which is a type of indicator that is more suited for day-trading or intra-day trading. All these rely on the same main principle of smoothening prices by taking the average price of the recent price action. However, due to their different formulas and also the components that go into each, there will be some variations as to how they appear on the chart, and ultimately, how well they work for your trading. One type of moving average which is a little different from the most basic ones, and which is the topic for this article, is the Volume Weighted Moving Average, also called VWMA.
VWMA, or Volume Weighted Moving Average, is a moving average that not only includes recent close prices, but also volume. However, while the calculation is different, its application in terms of the strategies you can trade is quite the same.
In this article, you’ll learn everything you need to know about the Volume Weighted Moving Average. This includes:
- How VWMA differs from normal moving averages in practical terms
- How VWMA is employed by many traders in trading strategies
- The Difference Between WVAP and VWMA
- And much more
What Is VWMA?
As its name implies, the volume-weighted moving average, abbreviated VWMA, is quite similar to a regular moving average. However, the main difference lies in that the VWMA also takes volume into account by giving close prices forming under high volume more weight than those that form under low volume.
The rationale behind the volume-weighted MA is that price moves occurring under high volume are more significant than those that occur under low volume. As such, the idea is that we’ll get a more accurate MA-line when volume is part of the equation.
In most cases, the WVMA, and simple moving average will show quite similar readings. However, in times when the volume is erratic and some days experience big outliers, this could change drastically. For instance, in times of great volatility, it’s quite common to see how markets are cast around, and how low and high volume days come one after another. In those cases, you could expect to see the Volume Weighted Moving Average Diverge from the SMA.
In the image below we have chosen to display the market crash throughout March and April 2020. The Red line is the simple moving average, while the blue line is the volume-weighted average. As you see, they follow each other quite closely, until the market enters much higher volatility conditions, and volume spikes. Then it becomes apparent that they’re using two quite different formulas.
Volatile occurrences like those above are the types of scenarios when some traders believe that the VWMA provides a more accurate indication of what’s actually happening in the market.
How is VWMA Calculated?
Despite involving more components than a plain, simple moving average, the Volume Weighted Moving Average is really easy to calculate. Instead of just averaging all the recent close prices, you average the recent close prices times volume.
So, if you were to construct a simple moving average of the last 2 bars, you would do the following:
SMA = (This close + Previous close)/2
To calculate the volume-weighted moving average, you would do the following:
VMWA= (Current close*volume + previous close*volume) / (Volume of current bar + volume of last bar)
As you see, it still remains simple and easy to remember.
Common VWMA trading strategies
Now you are probably wondering how traders go about to implement VWMA in their own trading strategies. Well, there are numerous ways you could use moving averages, and the implementations of VWAP are not very different from how traders usually go about implementing similar moving averages. Again, in some markets and timeframes, or in particular trading strategies, the VWMA might be better suited.
To know what types of strategies and markets that work best with the VWAP, you’ll have to perform some backtesting on historical market data. That way you’ll get a better sense of what has worked historically, as well as is likely to continue to deliver profits going forward.
With this said, we’re going to look closer at three types of strategies that are popular among traders.
- Breakout Trading
- Mean Reversion Trading
- Moving average crossovers
Even if these strategies are common and popular, it’s still important that you always make sure to test your strategies on historical data. You can never be sure that a strategy was designed for your particular market or timeframe, before you have tested it yourself.
With that said, let’s begin!
Breakout trading is a trading style where you attempt to catch strong price movements, expecting them to continue going in the direction of the momentum. Typically, breakout traders watch certain support or resistance levels and act on breakouts above or below these levels. Some common breakout levels are:
- The highest high or lowest low
- Pivot points
- Moving averages (such as the VWMA)
When it comes to using moving averages, many traders choose to watch long term averages, such as the 200, or 100-period moving averages. As such, they look to enter long positions when the market breaks up through the average, and short positions once it breaks down.
However, with the Volume Weighted MA, we can approach breakout trading in a slightly different way, considering how it takes volume into account. By using a VWMA and an SMA with the same periods, you have to lines that most of the time will be very similar to each other. However, at certain times, the VWMA is going to rise or fall sharply relative to the SMA.
Keeping the formula and characteristics of the VWMA in mind, a rapid increase in the indicator line means that recent up days have had much more volume than recent down days. As such, you could say that the VWMA has broken out, or deviated, from the SMA.
In the image below you see a perfect example of this. The VWMA takes off sharply to the upside, signaling that volume is overwhelmingly bullish, which is then followed by a sharp rise in prices.
Mean Reversion Trading
Mean reversion is a trading style that attempts to profit from the mean-reverting traits of many markets. In short, it means that prices tend to overextend themselves both to the upside and downside, which leads to a counter-reaction in the form of a price swing in the opposite direction. This counter-reaction, or reversion to the mean, is what we try to profit from as mean reversion traders.
Moving averages can play a big role in mean reversion strategies, either as part of the main exit or entry mechanism, or as a filter to support the strategy only to only trigger when the odds are the at their greatest.
For instance, many swing trading strategies that go long on oversold levels, only do so if the market is above its 200-period moving average. In other words, it only goes long when the long term trend is in support of the anticipated bullish price swing.
Other common applications of moving averages in mean reversion trading, is to measure the distance from the close to the MA. When it reaches a certain percentage threshold, it’s assumed that the market has become oversold, and is likely to turn around soon.
Another common approach is to use a fairly short term MA, such as 5-10 periods, as a profit target. Quite logically, most long trades are taken after the market has fallen, which makes it very likely that the close will be under the short term average.
In general, the volume-weighted moving average can be used just as regular moving averages in mean reversion trading. Just keep in mind that the results will differ a bit from those you will get from a simple moving average. Depending on the market, this surely could be a benefit!
The perhaps most common type of moving average signal is the crossover signal. In short, it occurs when a shorter-term average crosses over a longer-term average.
In the image above you see how the 50- period moving average crosses over the 200-period moving average, creating a signal that’s commonly referred to as a golden cross.
Now, one interesting twist to this commonplace strategy is to replace the short term SMA with a volume-weighted average. That way you not only rely on the direction of price itself, but also on the weight of each price move. As such, there is a chance that such a configuration would give less false signals, than when only using simple moving averages.
Volume Weighted Moving Average VS Volume Weighted Average Price: Is WVAP the same as VWMA?
Even though they may seem to be very similar, there are quite some differences between the volume-weighted average price and the volume-weighted moving average. Let’s look at them!
First and foremost, they are calculated in very different ways. While the Volume weighted MA in essence just adds the element of volume into the formula, the volume weighted average price works in a quite different manner. Here are the two major differences:
1. The Volume Weighted Average Price doesn’t use the close of the bar but the typical price, which is the sum of the low, close and high, divided by three. However, it doesn’t end there. The typical price is then multiplied by the volume of the current bar. You then cumulatively add all the values for every bar in the lookback period, and divide the number you get by the aggregate volume for the period.
2. The Volume Weighted Average is reset at the start of every trading session, which is not the case with the VWMA.
The second point renders the WVAP more suitable for day traders, since it is only concerned with the intra-day price moves of the current day. It’s also used by bigger market players who wish to get in or out of the market at a fair price.
If you want to read more about WVAP and how it’s used, we recommend that you have a look at our definitive guide to VWAP.
In this article, we have had a close look at the volume-weighted moving average, how it works, and how traders choose to trade the pattern. This included three types of trading strategies where the VWMA is used either on its own, or as a part of a greater trading strategy.
Before ending, we want to really stress the importance of never taking anything you hear online for granted. You always have to perform your own tests to validate your findings, and ensure that the methods and strategies you’ve chosen to trade actually work.
The best tool for evaluating strategy performance indeed is backtesting. In short, it means that you use a trading platform to simulate the performance of the trading strategy, using historical data and an easy coding language.
If you’re interested in learning more about how to build and create your own trading strategies, we recommend that you read ou article on how to build a trading strategy. There we have gathered a lot of useful information about the strategy creation process, and how to overcome common issues such as curve fitting!