VWAP

VWAP

It used to represent the bulk of algo trading activity. Currently it is second in popularity only to arrival price. 

Advantages of benchmarking to VWAP: 

- easy to compute

- intuitively accessible

 

Typical parameters of a VWAP execution: 

- start time

- end time

- # shares to execute

 

Additionally, optimized forms of this strategy require a choice of risk aversion. 

 

The most basic form of VWAP trading uses a model of the fractional daily volume pattern over the execution period.

A trade schedule is calculated to match this volume pattern. 

Example:

Assumption: Execution period is one day and 20% of a day's volume is expected to be transacted in the first hour. 

--> Trader using this basic strategy would trade 20% of his target in the first our of the day. 

-->Trader's VWAP pattern will have the same shape as the daily volume pattern. 

 

VWAP is an ideal strategy for a trader with the following criteria: 

- His trading has little or no alpha during the execution period

- He is benchmarked against the VWAP

- He believes that market impact is minimized when his own rate of trading represents the smallest possible fraction of all trading activity

- He has a set number of shares to buy or sell

 

Deviation from these criteria may make VWAP strategies less attractive. 

The period of a VWAP execution is most typically a day or a large fraction of a day. 

Several variations of the basic VWP strategy are common.

 

The ideal VWAP user can lower his expected costs by increasing his exposure to risk relative to the VWAP benchmark.

For example, assuming an alpha of zero, placing limit orders throughout the execution period and catching up to a target quantity with a market order at the end of the execution period will lower the expected cost while increasing risk --> highest risk strategy

Continuously placing small market orders in the fractional volume pattern is the lowest risk strategy, but has a higher expected cost. 

For a particular choice of risk aversion, somewhere between the 2 extremes is a compromise optimal strategy that perfectly balances risk and costs. 

 

For market participants with a positive alpha, a frequently used rule-of-thumb optimization is compressing trading into a shorter execution period. 

In another variant of VWAP - guaranteed VWAP - a broker commits capital to guarantee his client the VWAP price in return for a predetermined fee. 

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