Almost every security trader will rather go for a trading strategy that minimizes risks and increases chances of achieving success. And, the time-weighted average price (TWAP) is one such trade execution strategy.
TWAP reduces the impact of large orders on the security market, making it a perfect choice for high-volume traders. Furthermore, calculating the time-weighted average price uses an easy-to-understand formula. And, in this article, we will help you understand the time-weighted average price better, including how to calculate it.
What is the Time Weighted Average Price?
Time-weighted average price (TWAP) tells you the average price of a security over a predetermined period. TWAP is a relevant tool for effective trading as it offers traders an alternative strategy to executing large orders. Using the TWAP, you can break up a large order into smaller chunks to minimize the impact of large orders on the market.
The ultimate goal is to improve the price of security via executing trades evenly over a specified period. For instance, if you want to purchase 10,000 of a company’s shares, applying the TWAP strategy, you could break the trade down, purchasing 1,000 shares every 15 mins.
The Time-weighted average price is not so different from the Volume -weighted average price (VWAP). While the VWAP considers volume in its calculation, TWAP does not. Normally, VWAP is an ideal order execution algorithm, but not when you foresee unfavorable market price momentum.
How to Calculate Time Weighted Average Price
Calculating TWAP does not demand any complex mathematical procedure, you only need to master the formula. You can calculate TWAP by taking the average of the “typical price” – Open, High, Low, and Close price of each bar, and then calculating their averages for ‘n’ number of periods.
The formula for calculating TWAP is:
In application, assuming you want TWAP value for 5 periods, then:
- Take the Average of Open, High, Low, and Close values of each 5 bars – a1,a2,a3,a4,a5
- Take an average of a1 to a5. TWAP= (a1+a2+a3………..+a5)/5
However, if you are faced with daily prices with several after-hours movements, you should use the open, high, low, and close when factoring in the typical price. In cases where the open and close are similar, such as intraday prices on liquid stocks, using the open, high, and low is advisable.
When you have gotten the TWAP, it is also important to detect whether the security is overvalued or undervalued. To do this you have to compare the order price. An order price that is below TWAP indicates that the security is undervalued, and if above the TWAP, it is an indicator that the security is overvalued.
The time-weighted average price plays a major role in trading especially when you are dealing with large orders. By breaking down your order into smaller chunks and executing them within a specific period you could reduce the impact of large orders and improve price.