[jperl]

Throughout the previous threads (Part I,Part II and Part III), I have described the use of a probability distribution in the form of the volume distribution function as a trading tool. The shape of the probability distribution is dynamic, changing with time throughout the trading day. Nevertheless all information relating to price and price action is contained within this distribution function. Anything you want to know about price and price action can be obtained by analysis of the distribution function itself. No extraneous information from other sources is required.

We have so far analyzed the distribution in terms of two properties, a)the peak volume price ( PVP ) and b) the volume weighted average price ( VWAP ), which is the mean for the distribution. Both of these are dynamically updated throughout the trading day as the volume distribution function dyanmically changes. In Part III, we showed how the relationship between the VWAP and the PVP could be used for an entry technique in a simple newbie VWAP trading strategy.

But there is much more that is needed to advance beyond the newbie strategy. In this thread and succeeding threads, we will address the following issues:

1)Given an entry point, where should the profit target be set?
2)What other entry points are there beside the VWAP?
3)How can you tell when a reversal may be imminent?
4)When is a breakout imminent?
5)How do you trade the opening?
6)When should you be looking for scalps.?
7)How do you set stoplosses ?
and related to this
a)Should you set stoplosses?
b)when do you scale in?
c)when do you scale out?
d)When do you reverse a trade.?

.
While we won't address all these questions in one thread their answers can be obtained by analysis of the volume distribution function. To do so requires that we introduce a third property of the volume distribution function called the Standard Deviation of the VWAP, SD for short. SD is computed from the following equations:


where the summation subscript i, runs over all prices in the volume distribution
pi = ith price in the volume distribution
Pi = vi/V is the probability of occurrence of price pi
vi = the volume traded at price pi from the volume distribution
V = total volume for the entire distribution

That's a mouthful. If you would like more details about the variance and the standard deviation, see the wikipedia reference
http://en.wikipedia.org/wiki/Variance and references therein.

So what does the Standard Deviation tell you?
Well for starters,
SD tells you how far you can expect price to move away from the VWAP.

It can be shown (but we won't prove it here ) that computing the SD with respect to the VWAP gives the smallest expectation of price movement.

Put another way, if our newbie trader were to initiate a trade at the VWAP (which he/she already knows how to do from Part III), then the obvious place to put his profit target is 1 standard deviation away from his entry price. This is the least he should expect the price action to move price.

SD is thus a measure of market volatility for the time period over which the VWAP is computed. This gives NEWBIE a very powerful handle for his trading. If the SD is too small, he should stand aside. If it is too large, requiring a large stoploss, he might stand aside as well, if this frightens him. Too small and too large are of course qualitative terms which NEWBIE will have to decide for himself, but at least now he has a quantitative measure of market volatility and what he can expect when he enters a trade.

Watch the attached video ESlongJuly23.swf and see how adding the SD helps NEWBIE set his profit target.

After using the SD for profit targets, a light bulb goes off in NEWBIE's head. He realizes something about entry points that he didn't know about before. If he believes what he is thinking, it will totally change his way of trading now and forever. Can you tell what it is?
Check out part V to see what it is.

[Dogpile]

Jerry,

it looks like a 2-minute chart, is that right?

also, just to clarify -- the std dev is for all closing 2-min bars that day vs all respective 2-min VWAP closing values for that day?

[Nvesta81]

Very interesting, love the videos. Thanks!

Just a question to make sure I'm clear on something. When the price is below the VWAP and around the PVP, the reason not to take trades assuming it's going to go back up to the VWAP and possibly up to the SD - is it that the area is considered more 'random' than at around the VWAP? Because my first instinct looking at that video as a newbie is "hmmm well if the price seems to gravitate toward the VWAP and possibly upward to the SD, why wouldn't I enter the trade down here instead of waiting for it to touch the VWAP".

So I'm assuming it has to do with less probability and that prices could continue to drop if they are at or lower than the PVP, whereas at the VWAP probability is on your side that it will continue to rise?

[jperl]

Originally Posted by Dogpile »

it looks like a 2-minute chart, is that right?

Yes, 2 minute chart, but there is nothing special about using 2 minute chart, you could use any time or type chart you wanted. The volume distribution function would be the same. That's the beauty of market statistics. The VWAP only depends on when you start the computation.

Originally Posted by Dogpile »

also, just to clarify -- the std dev is for all closing 2-min bars that day vs all respective 2-min VWAP closing values for that day?

Not sure what you are asking, but let me state how the SD is computed by example. Suppose it is 12:30. Compute the VWAP from the open until 12:30. The value you get is the 12:30 VWAP value. It is that one value that is used to compute the SD at 12:30 using all prices in the subtraction from the open until 12:30.
As far as what prices to use, in principle it should be the prices for every trade. In practice this is too CPU intensive. Most computations use either the close of each bar or the average (O+H+L+C)/4 of each bar. It is not too critical.

[jperl]

Originally Posted by Unleashed »

So I'm assuming it has to do with less probability and that prices could continue to drop if they are at or lower than the PVP, whereas at the VWAP probability is on your side that it will continue to rise?

Good observation Unleashed, you are getting the feel for this. You indeed could take a trade at the PVP, but our NEWBIE is not ready for that yet. Trades at the PVP are possible but dangerous. We will discuss this in a later thread when we get to reverse trades and break outs.

[losfer]

Does anyone know how i can plot the standard deviation of the vwap on sierra chart
thanks for your help

[jperl]

Originally Posted by losfer »

Does anyone know how i can plot the standard deviation of the vwap on sierra chart
thanks for your help

Sorry losfer, not familiar with Sierra. I would recommend that any charting program that is supplying VWAP should be requested to add the standard deviation as a choice. Otherwise you will be in the dark about market volatility.

[darthtrader]

another great video Jerry.
Unleashed, funny thing with what you mentioned because I had the same first instinct as a newb. Its interesting if you compare that to market profile too because wouldnt that basically be like trading the value low pivot in mp if you went with that lower std dev instead of waiting?

also, I would think with any package that has vwap and a scripting language that it shouldn't be to hard to gut bollinger band code to get vwap std dev. Even if the package didn't have a std dev function the math would all be done in the bb indicator. You would just have to swap vwap for the ema and kill the back lookup period.