Most traders have had the frustrating experience of buying a stock and then watching as the price drops over the ensuing minutes or hours. One way to alleviate this problem and increase your execution efficiency is by using TWAP or VWAP orders.
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TWAP is an abbreviation for Time-Weighted Average Price, while VWAP stands for Volume-Weighted Average Price. Both of these mechanisms calculate an average price across some time period ranging from a minute to several hours. If your broker allows you to place TWAP or VWAP orders, then you can be certain that your trade will be executed at a price somewhere between the best possible and worst possible price that occurs during the specified time period. Your execution price will depend on which algorithm is used, as well as how it’s implemented.
TWAP is very easy to understand; all you need to know is the time duration and the sampling period. The price of the stock is recorded (sampled) once during each sampling period during the overall duration, and these samples are then added together and divided by the number of samples to determine the average. For example, if you place a TWAP order at 11:15 AM with a duration of 5 minutes and a sampling period of 1 minute, then the TWAP will be:
Even if your broker does not support TWAP entries, you could implement this yourself fairly easily, although it might be somewhat tedious. For example, if your goal was to buy 1000 shares of stock with a 5 minute TWAP order, you could simply place 5 market orders for 200 shares each, entering the orders one minute apart.
VWAP is somewhat more sophisticated than TWAP, and also more popular with traders. Weighting the stock price by the volume traded gives a better idea of the market’s perception of the current value of the stock. The formula for VWAP during a specified time period is:
VWAP = Σ (Number of Shares Traded x Price) / Total Shares Traded
This simplifies to:
VWAP = Total Dollar Value of Shares Traded / Total Shares Traded
VWAP can only be implemented by your broker, as there is no practical way for you to implement it yourself. Some brokers offer both a “best effort” VWAP order as well as a “guaranteed” VWAP order, which typically involves a higher commission. Once you understand your broker’s offerings and the associated fees, you’ll be able to determine if these order types make sense for you.