Wednesday, April 17, 2024

Time Weighted Average Price (TWAP)

Time Weighted Average Price (TWAP) is a trading algorithm based on weighted average price that is used to execute larger orders without having too much impact on the market price.

A running strategy may have trading patterns that are easy to guess without special modifications, so parameters can be adjusted to make the strategy harder to track.

The most common solution is to randomize the order size and/or the delay between orders.

Quantities can be limited to no more than a defined percentage of the quantity to minimize the impact of the strategy on the market.

Time Weighted Average Price (TWAP) is another trading algorithm based on weighted average price.

Its calculation is simpler than the volume weighted average price. I

It is one of the earliest execution algorithms, and unlike most algorithmic trading strategies, it is a passive execution algorithm that waits for the appropriate market price to arrive rather than chasing it.

How to use TWAP

The most common use of TWAP is to distribute large orders throughout the trading day.

For example, you want to buy 100,000 shares of Apple stock.

Placing a large order may impact the market, causing prices to rise. To prevent this, you can define the time period during which you want to buy stocks.

The TWAP algorithm will evenly split large orders into smaller orders and execute them within a defined time period.

TWAP can be used as an alternative to VWAP, but due to its simplicity, it has some drawbacks.

Even if you cut large orders, since you are cutting evenly, it is still possible to trade during periods of lower liquidity and your cut orders will still have an impact on the market.

This is why it is recommended to use TWAP in the short term or on assets that do not have any available volume profiles.

Random order

Trading in this predictable manner may cause other traders or predatory algorithms to detect your strategy and start “cheating” on you.

You can add randomness by focusing on completion percentage over a period of time rather than a fixed amount.

In practice, this means that when we run 1 hour TWAP, you don’t split the order into even parts. Instead, your goal is completion percentage.

For example, you could aim to complete 25% of your strategy in the first 15 minutes, 50% in the second minute, and 75% in the third minute.

This gives greater freedom in order size and makes your orders appear more random and less predictable.

TWAP vs. VWAP

Although VWAP is more complex as it includes trading volume in the calculation, on lower volume instruments the TWAP and VWAP values ​​can be close.

On the other hand, when the trading session starts to get choppy, both indicators will diverge.

The TWAP and VWAP in the table below are calculated for the entire trading day.

As we can see, at the beginning of the trading day, the difference was less than a cent, but by the end of the trading day, the difference rose to 2 cents.

This happens because, during the day, there are some low-volume, low-price transactions that impact TWAP, but not VWAP.

TimeCloseHighLowOpenTWAPVWAP09:44:00100.81100.85100.80100.85100.900100.90409:45:00100.69100.80100.67100.80100.890100.88715:57:00100.70100.70100.68100.69100.666100.68615:58:00100.71100.72100.68100.70100.666100.686

If you want to learn more foreign exchange trading knowledge, please click: Trading Education.

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