Time Weighted Average Price is a trading algorithm based on weighted average price. Its calculation is simpler than that of Volume Weighted Average Price, with there being plenty of benefits to TWAP. Time Weighted Average Price is an execution strategy which trades in execution of order quantity at regular intervals of time based on the users specification. It adds randomization as per an algorithm to minimize gaming risk during execution.
TWAP strategy uses more complex ways of buying and selling than simply executing orders. Business personalities that trade on high volume products use Time Weighted Average Price to execute their orders over a specific time so as to keep the price close to what reflects as the current market price. A TWAP trade is likely to execute fifty-fifty volume of stock in the first and the second half of the day since it does not consider volume in its execution. Since Time Weighted Average Price does not consider volume, it is simple to obtain.
Best Use of TWAP
The most popular use of Time Weighted Average Price Strategy is for distributing big orders throughout the trade process. An illustration: let’s say you want to buy one hundred thousand shares. Putting such a big order at once would vastly impact the market and the price most likely would start to rise. To prevent that, investors can define time period in TWAP Strategy over which they want to buy shares. It will cut evenly a big order into smaller ones and execute them over a defined period.
TWAP strategy could be used as an alternative to Volume Weighted Average Price strategy, but because of its simple form we have to remember about some of the important things. Even if we cut big orders, we do it evenly, hence there is a possibility to hit on low liquidity period when our sliced order will impact the market hard. That’s why it’s recommended to use TWAP strategy over short periods or on stocks that are believed to not have any volume profile to follow.
When and Why to Choose TWAP Strategy
• When executing large orders in a short time frame.
• When expecting extreme price movement with large volume; Time Weighted Average Price Strategy may give better execution price than Volume Weighted Average Price Strategy in such case.
• To reduce the market impact by executing smaller volume of orders quickly.
• The TWAP strategy may use iceberg orders or disclose minimal order quantity to minimize price impact.
• The Time Weighted Average Price is useful when a methodological and predictable execution schedule is needed.
• Can also be used on illiquid stocks with a percentage Volume limit.
There are general parameters that help in deciding what is essential for TWAP strategy, even though the actual TWAP strategy parameters depends on the trader.
Start Time: No orders are sent to the market even if there is buy/sell signal before start time.
End Time: All open orders are completed before End Time regardless of the market impact.
Percentage Volume: The strategy automatically adjusts the participation rate to limit it to the percentage of stocks total traded volume.
Price Band: The desired price band for the average traded price. If market moves beyond the price band limit, the order will not be completely executed.