Time-weighted average price (TWAP) calculates the weighted average price of the security over a particular time period. TWAP is often implemented as an order execution strategy to execute massive trades by breaking them into equal parts over a trading period to minimize slippage and signaling.
What Is TWAP?
TWAP or Time-weighted Average Price is a calculation that defines the weighted average price over a specified period. Traders use TWAP as a trading strategy, specifically, an execution strategy, to place large orders without excessively impacting the market price. They break down the large orders into several sets of small orders priced near TWAP.
For example, if a trader wants to purchase 20,000 shares of a company, they could choose to buy 1,000 shares every 20 mins for 6 hours and 20 minutes, depending upon timing needs.
See the chart below displaying TWAP.
The Time-weighted average price is similar to Volume -weighted average price (VWAP). However, it differs because there isn’t a volume element in its calculation. TWAP is one of the most straightforward execution strategies for disseminating trades over a specific time and lowering its impact in the broader market.
Why Use TWAP?
Traders use TWAP as an execution algorithm to break down large, market-impacting orders into smaller digestible chunks. By doing so, traders can minimize the impact of a large order on the market price.
TWAP can be used as an alternative to VWAP, but it has certain drawbacks for intraday execution. Volume isn’t linear. Typically, volume is most substantial near the open and close. Spreading order flow evenly across the day isn’t optimal. Depending upon the order size, it may signal to other traders that an institution is likely taking a prominent position. Even if the large order goes unnoticed, it may execute at suboptimal prices. Hence, TWAP is best used on higher-volume securities or over multiple days.
Typically VWAP is a better order execution algorithm, except when you expect negative market price momentum.
TWAP Formula
To calculate TWAP, we have to take the average “typical price” for n periods. For daily prices with lots of after-hours movement, use the open, high, low, and close when factoring in the typical price. For intraday prices on liquid stocks where the close and open are similar, use the open, high and low.
tp = (Low +Close + High) / 3
TWAP = (TP_1 + TP_2 + TP_n) / n
It’s a simple calculation without any complex mathematical equations. After arriving at the TWAP, the order price is compared to determine if the security is overvalued or undervalued. If the order price is below the TWAP, it is considered undervalued, while if it is more than the TWAP, it is considered overvalued.
Calculating VWAP in Python
The following function calculates the VWAP for each session period and the group by grouping the session into a single dataframe.
# Get imports
import datetime
import pandas as pd
# Create example dataframe
df = pd.DataFrame(
index=[datetime.datetime(2021,1,1,1),
datetime.datetime(2021,1,1,2),
datetime.datetime(2021,1,1,3),
datetime.datetime(2021,1,1,4)],
data={'low':[9,10,11,12],
'close':[10,11,12,13],
'high':[11,12,13,14],
'volume':[1000,750,500,250]
}
)
df.index.rename(‘date', inplace=True) low close high volume
date
2021-01-01 01:00:00 9 10 11 1000
2021-01-01 02:00:00 10 11 12 750
2021-01-01 03:00:00 11 12 13 500
2021-01-01 04:00:00 12 13 14 250# Create VWAP function
def twap(df, period):
tp = (df['low'] + df['close'] + df['high']).divide(3)
return df.assign(twap=(tp.rolling(period).sum().divide(period))
twap(df, 2).dropna() low close high volume twap
date
2021-01-01 02:00:00 10 11 12 750 10.5
2021-01-01 03:00:00 11 12 13 500 11.5
2021-01-01 04:00:00 12 13 14 250 12.5# Verify VWAP
## Can use close price as it's the same as tp
(10 + 11) / 2
10.5 # correct, matches our dataframePros & Cons of TWAP
Benefits
TWAP proves to be a straightforward and beneficial execution strategy when appropriately executed. Some of its significant advantages are:
Simplicity
The main advantage of TWAP is the simplicity of the execution algorithm. It wouldn’t be a challenge for a discretionary trader to manually execute a TWAP strategy on a single or a few exchanges.
Risk Mitigation
Like all execution algorithms that reduce large orders into multiple smaller orders, TWAP reduces both slippage and signaling risk.
Drawbacks
The primary drawback of TWAP is a linear execution model as intraday volume isn’t linear. This incongruence causes two significant risks.
Signaling Risk
Trading in a predictable pattern may signal risk for orders that take up a noticeable daily volume percentage.
Suboptimal Intraday Execution
Intraday TWAP execution breaks up orders into multiple similar amounts spread throughout the day; however, for low volume securities where volume isn’t consistent during the day, this can lead to order execution as suboptimal prices and potentially signaling risk.
To see this clearly, look at the volume profile on the SPY chart below. You’ll see it peaks at the open and the close.
TWAP FAQs
TWAP vs. VWMA
| TWAP | VWMA | |
|---|---|---|
| Meaning | TWAP is the calculation that defines the weighted average price of an asset over a period. | VWMA stands for Volume Weight Moving Average. VWMA is a moving average; that assigns a different weight to each closing price. |
| Component | TWAP doesn’t take volume into account. It only focuses on price and time. | The indicator calculates the average of closing prices with respect to the volume. |
| Objective | TWAP is instrumental in disseminating trades over a specific time period and lowering its impact on the broader market. | VWMA is instrumental in discovering emerging trends and confirming existing trends by studying the price and volume pattern. |
| Formula | The average of the opening, high, low, and close price, also known as the typical price, is divided by the number of trading d.tp = (Low +Close + High) / 3TWAP= ((TP1+TP2+….TPn)/n) | The indicator calculates the average of closing prices with respect to the volume.(C1V1 + C2V2 + C3*V3) / (V1+ V2+ V3) |
TWAP vs. VWAP
| TWAP | VWAP | |
|---|---|---|
| Meaning | TWAP, or Time-weighted Average Price, is a trading algorithm defining the weighted average price over a specified period. | VWAP or Volume Weighted Average price computes the average based on the number of shares traded at different prices throughout the trading day divided by the total number of shares transacted. |
| Component | TWAP is weighted based on time | VWAP is weighted based on time and volume. |
| Objective | Traders use TWAP to execute large orders without excessively impacting the market price. | Traders use the VWAP strategy to determine an attractive price and profitable entry and exit points. |
| Formula | The average of the opening, high, low, and close price, also known as the typical price, is divided by the number of trading days.tp = (Low +Close + High) / 3TWAP= ((TP1+TP2+….TPn)/n) | The summation of the typical price and the volume is divided by the cumulative volume.VWAP = (Typical Price x Volume) / cumulative volume. |
The Bottom Line
Time-weighted price (TWAP) is a simple order execution strategy. The main objective of the TWAP trading strategy is to prevent slippage and not signal to other traders what move you’re making in the markets.
When execution price is predictable, volume-weighted average price may be a better intraday trading algorithm due to the non-linear volume properties of a typical trading day.
