Insights and research on different algorithmic strategies
Time-Weighted Average Price (TWAP) is another trading algorithm based on weighted average price and in compare to Volume-Weighted Average Price its calculations are even simplier. Also it’s one of the first execution algorithms and unlike most algorithms nowadays it’s passive execution algorithm that waits for proper market price to come, doesn’t chase it.
As TWAP doesn’t bother about volume it’s extremely simple to obtain it. All it takes is to get Typical Price for every period bar using equation below and then calculate average of Typical Prices.
Typical Price = (Close+High+Low+Open)/4
Let’s just take a look at example results calculated on 1-minute interval intraday Morgan Stanley’s stock.
The most common use of TWAP is for distributing big orders throughout the trading day. For example let’s say you want to buy 100,000 shares of Morgan Stanley. Putting one such a big order would vastly impact the market and the price most likely would start to raise. To prevent that, investor can define time period in TWAP Strategy over which they want to buy shares. It will slice evenly big order into smaller ones and execute them over defined period.
TWAP could be used as alternative to VWAP, but because of itssimplicity we have to remember about some pitfalls. Even if we slice big orders, we do it evenly, thus there is a possibility to hit on low liquidity period when our splitted order will impact the market hard. That’s why it’s recommended to use TWAP over short periods or on stocks that are believed to not have any volume profile to follow.
There is also another threat coming directly from dividing big order evenly, namely, other traders or predatory algorithms. Obviously trading in such a predictable way can lead to situation where other traders or algorithms would look through our strategy and start to “game” us.
Barry Johnson in his book suggests adding some randomness to the strategy as a solution to the issue. He says that “We can use the linear nature of the target completion profile to adopt a more flexible trading approach. At any given time, we can determine the target quantity the order should have achieve just by looking up the corresponding value on the completion rate chart.”
In practice it means that when we have run 4-hour TWAP we don’t slice the order into evenly parts, but otherwise we focus on percentage completion. So for instance we would want to have 25% of the strategy completed by first hour, 50% by second and 75% by third. That gives a more freedom into size of orders, so we can be more random with it and hence less predictable for other traders on the market.
TWAP vs VWAP
As both indicators use same mechanism, i.e. weighted average price, it’s common to compare them. Despite that VWAP’s nature is more complex and includes volume in its calculations, on instruments with low turnover TWAP and VWAP values can be close. On the other hand when a session starts to be more volatile both indicators will diverge.
On a table below there are TWAP and VWAP calculated for whole trading day. As we can see at the beginning of the trading day the difference is less than a cent, but on close the difference raised up to 2 cents. It happened because during the day there were some small volume trades for lower price that didn’t affected VWAP, but did TWAP.
TWAP Strategy is another great tool for executing big orders without impacting the market too hard. Like everything it has its own pros and cons and it’s up to us to select if TWAP will be the best strategy to use for our case or maybe we should consider using VWAP or other strategy.
- H. Kent Baker, Greg Filbeck. “Portfolio Theory of Management” (2013) , pp.421
- Barry Johnson “Algorithmic & Trading DMA – An introduction to direct access trading strategies” (2010), pp. 123-126
Nanex released a video showing the results of half a second of worldwide high frequency trading with Johnson and Johnson stock. I simply sped up the footage to get a better feel of what it looked like. Blow Your Mind.
CNN’s Maggie Lake gets a rare look inside the super-fast trading industry.
Dr. Sean Gourley is the founder and CTO of Quid. He is a Physicist by training and has studied the mathematical patterns of war and terrorism. He is building tools to augment human intelligence.
Citadel Group, a high-frequency trading firm located in Chicago, trades more stocks each day than the floor of the NYSE.
One of the scariest high frequency trading algos ran in the electronic S&P 500 futures (eMini) contract on January 14, 2008 starting at 2:01:11Eastern. During its 7 second reign, there were over 7,000 trades (52,000 contracts), and the price eventually oscillated within milliseconds, the equivalent of about 400 points in the Dow Jones Industrial Average!
HFT is controlled by proprietary trading firms and spans across multiple securities, including equities, derivatives, index funds and ETFs, currencies and fixed income instruments.For HFT, participants want the following infrastructure in place:
– High speed computers, which need costly and regular hardware upgrades;
– Real time data feeds, which must avert even the delay which could affect profits; and of a microsecond
– Computer algorithms, which are the heart of HFT and AT.
Benefits of HFT
– HFT is beneficial to traders, but does it help the total marketplace? Some market that is overall gains that HFT assistants cite contain:
– Bid-ask spreads have reduced due to HFT trading, making markets more efficient. Empiric evidence contains that after Canadian authorities in April 2012 imposed fees that deterred HFT, studies indicated that “the bid-ask spread rose by 9%,” possibly due to diminishing HFT trades. And thus facilitates the effects of market fragmentation.
– HFT assists in the price discovery and price formation process, as it is centered on a high number of orders (see related: How The Retail Investor Profits From High Frequency Trading.)
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