Playbook Entry: Rule – Trade Away from VWAP

This one saves my bacon – I ignored it for a while but I’ve been noticing losers categorically fit into breaking this rule very often. I picked this idea up from SMB – my comment was “this rule was made for me.” It has been helping me fix macro bias and ensure I’m trading what the market is telling me, not what I think.

One of the most powerful, yet often overlooked, concepts in active trading is the relationship between price and the Volume Weighted Average Price (VWAP). A simple rule – trade away from VWAP, never towards it – can significantly improve trade selection, manage risk, and combat the pervasive influence of trading biases and emotions. Let’s break down why.

What is VWAP and Why Does it Matter?

VWAP is, at its core, a benchmark. It represents the average price of a security over a specific period, weighted by volume. This means that trades executed at higher volumes have a greater impact on the VWAP calculation. Institutional traders often use VWAP as a target or benchmark for their large orders, aiming to execute close to the average price to minimize market impact.

The key takeaway is this: VWAP acts as a dynamic level of support or resistance, and, crucially, it follows price, it does not lead price. This lagging characteristic is what makes trading away from it so valuable.

The “Trade Away From VWAP” Rule: A Trend Filter

The core principle is straightforward:

• For Long Trades: Look for opportunities to buy above VWAP, ideally when price is moving away from it (i.e., price is increasing and pulling further above VWAP).
• For Short Trades: Look for opportunities to sell below VWAP, ideally when price is moving away from it (i.e., price is decreasing and pulling further below VWAP).

Why does this work? Because it inherently aligns you with the prevailing intraday trend.

• Price Above VWAP (and Moving Away): Suggests buying pressure is exceeding selling pressure. More volume is being transacted at higher prices, pushing the average price (VWAP) upwards. You’re joining a potential uptrend.
• Price Below VWAP (and Moving Away): Suggests selling pressure is dominant. More volume is being transacted at lower prices, pulling the average price (VWAP) downwards. You’re joining a potential downtrend.

Combating Bias and Emotions

Trading biases (confirmation bias, recency bias, loss aversion, etc.) and emotions (fear, greed, hope) are the enemies of consistent profitability. The “trade away from VWAP” rule acts as a powerful antidote:

• Objectivity: It provides an objective, data-driven filter. You’re not relying on gut feelings or subjective interpretations of chart patterns alone. The VWAP is a mathematical calculation, removing a layer of emotional decision-making.
• Confirmation, Not Prediction: You’re not trying to predict where the price will go. Instead, you’re confirming that a trend is already in motion (at least in the short term) before entering. This reduces the temptation to chase price or enter prematurely.
• Reduced FOMO (Fear of Missing Out): By waiting for price to move away from VWAP, you’re inherently being patient. You’re less likely to jump into a trade impulsively just because the price is moving.
• Risk Management: If you buy above VWAP and the price reverses, crossing back below VWAP, it’s a clear signal that your initial thesis (uptrend) is likely invalidated. This provides a natural stop-loss level, further enforcing discipline.

Practical Application: Anchored VWAPs and Multi-Timeframe Analysis

To strengthen the VWAP rule, we can use “anchored” VWAPs and consider multiple timeframes:

1. Anchored VWAPs: Instead of just using the standard intraday VWAP (anchored to the day’s open), consider:
   • Session VWAP: Anchored to the start of a specific trading session (e.g., London open, New York open).
   • Weekly VWAP: Anchored to the start of the trading week.
   • Daily VWAP: Anchored from the start of a day, often the previous day for a next day outlook.
   • Swing VWAP: Anchored to a significant swing high or low on a higher timeframe (e.g., daily or 4-hour chart). This helps identify longer-term trends.
   • Event Driven VWAP: Anchored to a certain event, like an earnings release, to gauge reaction.
2. Multi-Timeframe VWAP Alignment: The strongest signals come when multiple VWAPs align. For example:
   • For a long trade, ideally, price should be above the intraday VWAP, and above the weekly VWAP, and above a swing VWAP anchored to a recent swing low. This suggests a confluence of buying pressure across different time horizons.
   • Conversely, for a short trade, price should ideally be below multiple anchored VWAPs.
3. VWAP Slope: Don’t just look at whether price is above or below VWAP. Observe the slope of the VWAP itself.
   • An upward-sloping VWAP indicates a strengthening uptrend.
   • A downward-sloping VWAP indicates a strengthening downtrend.
   • A flat VWAP suggests a lack of clear direction (consolidation).

Example:

Imagine you’re looking at a stock on a 5-minute chart.

• Good Long Setup: The price is above the intraday VWAP, and the VWAP is sloping upwards. The price is also above the weekly VWAP. You see a pullback towards the intraday VWAP, but it holds as support, and then price starts moving higher again, away from the VWAP. This is a potential entry point.
• Bad Long Setup: The price is above the intraday VWAP, but the VWAP is flat or sloping downwards. The price is also below the weekly VWAP. Even if the price is moving up momentarily, it’s moving towards the weekly VWAP (resistance), and the overall trend (as indicated by the VWAP slopes) is not clearly bullish. This is a trade to avoid.

Exceptions and Caveats

No trading rule is perfect, and there are exceptions to the “trade away from VWAP” principle:

1. Post-Capitulation Reversals: After a massive, sharp sell-off (capitulation), price may initially spike below VWAP and then quickly reverse. In these situations, a rapid move back above VWAP, accompanied by high volume, can signal a potential bottom and a buying opportunity. This is a more advanced technique that requires careful risk management.
2. News-Driven Moves: Major news events (earnings releases, FDA approvals, etc.) can cause price to deviate significantly from VWAP. In these cases, the initial reaction may be more important than the VWAP relationship. However, after the initial volatility, the VWAP rule can often be reapplied.
3. Low-Volume Environments: In very low-volume conditions (e.g., pre-market, after-hours, or illiquid stocks), VWAP can be less reliable. The lack of volume can lead to erratic movements and false signals.
4. Range-Bound Markets: When a stock is consolidating in a tight range, price may oscillate around VWAP repeatedly. In these situations, the VWAP rule is less effective, and other techniques (e.g., range trading) may be more appropriate.
5. VWAP Breaks: A trade may be planned, but during the execution, price breaks back to VWAP, violating the rule. This often requires a judgement call, however the rule breaking should give pause for thought.

Conclusion

The “trade away from VWAP” rule is a powerful tool for disciplined trend following. It provides an objective filter, helps manage risk, and combats the influence of trading biases and emotions. By incorporating anchored VWAPs and multi-timeframe analysis, traders can further refine their entry signals. While exceptions exist, understanding and applying this principle can significantly improve trading consistency and profitability. It’s not a magic bullet, but it’s a valuable framework for making more informed and less emotionally driven trading decisions. Remember to always combine this rule with proper risk management, position sizing, and a comprehensive trading plan.