Back to the basics: What is a VWAP?

By: ispeculatornew
Date posted: 03.15.2011 (5:00 am) | Write a Comment  (1 Comment)

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If you look in Wikipedia, you will see the standard definition of a VWAP: “VWAP is a trading acronym for Volume-Weighted Average Price, the ratio of the value traded to total volume traded over a particular time horizon (usually one day). It is a measure of the average price a stock traded at over the trading horizon.”

So what does this mean in clear terms?

Basically, longer term investors often want to get into rather large positions but buying those actual stocks is not as easy as it may sound. Why? Because of all of the day traders for one. For example, an investor that wants to buy 3 million shares of Apple over 5 days might want to do a VWAP. There are many ways to get it done but the one huge mistake would be to do a market order on 3 million shares. There are several reasons why you do not want to do that:

-At all times, there will be investors wanting to buy and sell shares of Apple and they will be posting “bid” and “ask” offers. So you might have the following:

10,000 shares @ 356.65$
20,000 shares @ 356.64$
17,000 shares @ 356.63$
20,000 shares @ 356.62$
many other orders @ lower prices

17,000 shares @ 356.66$
11,000 shares @ 356.67$
38,000 shares @ 356.68$
47,000 shares @ 356.69$
many other orders @ higher prices

If you place an order to buy 3 million shares of Apple at a market price, you will be hitting those “ask” prices and I can tell you that your execution price will be terrible because instead of buying Apple at the “current price” of $356.65, you will end up paying much more as not enough investors will  be ready to offer shares at that time. You might get your entire execution but the price will be very bad.

Another key aspect is that day traders and high frequency traders will see that you want to buy a large quantity of Apple (AAPL) shares and they will drive the prices up (more on that tomorrow). So no, you do not want to make a market order. The best option is to spread the buying over a day or several days. How? In the past, traders would manually put orders but splitting 3 million shares over 5 days would be a hectic and very imprecise science wouldn’t it?

In comes the VWAP

Electronic trading has its pros and cons but its benefits are important even for long term investors. How? In this case, algorithms are programmed to trade the stock over several days. For example, in this case, the algo would try to buy 500,000 shares every day. How? Well that is slightly under 77,000 shares per half hour or 2564 shares per minute. So to simply the process, the VWAP algo would buy 2500 shares or so every minute for the entire day. In the process it would also adjust for a few elements:

-The algo tries to get the best execution price available and will adjust its buying speed depending on how it is going
-The also tries to replicate the volume weighted price of Apple so if the stock starts to trade less, the algo will do the same and will do the opposite when volume picks up

Is it that simple?

Not quite. Tomorrow I will explain the challenges of executing through a VWAP and what makes some algos better than others.

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