VWAP Algorithm

 

Volume-Weighted Average Price known as VWAP is one the most basic and commonly used market indicators by traders around the world. In a book “Algorithmic & Trading DMA” we can read about VWAP that  “As a benchmark, it rapidly became ubiquitous since it gives a fair reflection of market conditions throughout the day and is simple to calculate. This led to algorithms that tracked the VWAP benchmark becoming extremely popular.”

 

Calculations

 

Calculation of VWAP it’s relatively simple and it can be done even on piece of paper for small amount of data. In mathematical approach VWAP is represented by equation below:

 

wzor 1.jpg

 

where P is the price of i-th trade and V is the size related to i-th trade. In fact it takes five steps to calculate your first VWAP. First, only if we use intraday data for examination, we need to calculate typical price for our intervals. Then multiply the price by period’s volume and create running total of these values for future trades. Fourthly we create cumulative volume and in the end we divide cumulative multiplication of price and volume by running total of volume to obtain VWAP. Even simpler, VWAP is a turnover divided by total volume.

 

Let’s take a look at example results calculated using these five steps on 1-minute interval intraday Morgan Stanley’s data.

Time Close High Low Open Volume Typical Price Price*Volume Total PV Total Volume VWAP
09:30:00 38.90 38.96 38.90 38.96 69550 38.93 2707581.50 2707581.50 69550.00 38.930
09:31:00 38.94 38.97 38.86 38.92 27617 38.92 1074922.68 3782504.18 97167.00 38.928
09:32:00 38.91 38.96 38.91 38.94 11441 38.93 445398.13 4227902.31 108608.00 38.928
09:33:00 38.89 38.94 38.88 38.92 23587 38.91 917710.61 5145612.93 132195.00 38.924
09:34:00 38.90 38.94 38.90 38.90 10771 38.91 419099.61 5564712.54 142966.00 38.923
09:35:00 38.97 38.97 38.90 38.90 12721 38.93 495276.23 6059988.77 155687.00 38.924
09:36:00 38.92 38.96 38.92 38.96 16471 38.94 641384.86 6701373.63 172158.00 38.926
09:37:00 38.90 38.93 38.86 38.93 23788 38.91 925472.14 7626845.77 195946.00 38.923
09:38:00 38.90 38.92 38.89 38.89 9170 38.90 356701.54 7983547.30 205116.00 38.922
09:39:00 38.92 38.92 38.88 38.91 4644 38.91 180682.02 8164229.32 209760.00 38.922
09:40:00 38.90 38.92 38.88 38.91 4917 38.90 191283.59 8355512.92 214677.00 38.921

All calculations are pretty straightforward, but let us take a look at one interesting element. When you look at typical prices more than half of them (7/11) is below the last VWAP At the same time mean equals 38.917. So where does the difference come from? Volume is the culprit. In our case, period with higher typical price also has bigger Volume, thus bigger market impact and VWAP calculations indicate that.

 

Intraday or tick

 

The most classical VWAP approach is based on tick-by-tick data. But as the market grows and frequency of trades increases more resources are required to keep all calculations up-to-date. Nowadays it is nothing extraordinary for stock to have over hundred trades per minute (true or false?). When multiplied by minutes in a trading day and number of stocks it develops into numbers that might cause some performance troubles.

 

With help arrives intraday data, i.e. tick-by-tick data aggregated in time periods e.g. 1-minute, 5-minute or 15-minute that contains close, high, low and open price. As in VWAP calculations only one price is required we have to somehow average available prices. For this task exist typical price:  

 

typical

 

Also there is a second version of typical price that includes Open Price and it’s divided by 4.

 

Strategy

 

Most likely we can point out two different strategies of reading VWAP. First one used especially by short-term traders relies on waiting for VWAP to cross above the market price and then enter long position as they interpret price to be bullish. On the other hand are Institutions looking to sell at this moment because they consider it as good opportunity for that day’s price.

 

When the price goes below VWAP value, the trend seems to be down. Institutions recognize it as good moment to buy, but short-term trader will look to short that stock.   

 

Surely it’s basic approach to VWAP interpretation. For your strategy you would like to scrutinize e.g. influence of price deviation from VWAP value. You should consider that VWAP behaves differently based on period of trading day. It’s because of VWAP cumulative nature. VWAP value is very sensitive for price changes at the beginning of day, but insensitive at the end of trading day.

 

Big Fish

 

VWAP is surely commonly used between traders with strategies described above, but on the market there is a bunch of various indicators like VWAP that can suggest when to buy or sell shares. But there is other side of the fence.

 

Let’s say you want to buy 5 million shares of Morgan Stanley that is 37% of average daily volume in 2014. You cannot buy them at once, because that will impact significantly the market and the market will start to go against you. What you want to do is split the order in small pieces and execute them without impacting the market. Doing it by hand would be backbreaking, that’s what trading application has been made for.

 

Using trading application and VWAP Strategy, utilizing historical minute intraday files, you can easily generate average volume period profiles that will steadily buy proper number of shares without impacting the market.

 

Improve your VWAP

 

As we mentioned in previous paragraph there is a way to improve VWAP performance by creating volume profiles based on historical data. According to Kissel, Malamut and Glantz optimal trading strategy to meet VWAP benchmark can obtained by using equation:

 

wzor 3.jpg

 

where X is the total volume traded, uj is percentage of daily volume traded and xj is target quantity for each j-th period. Hence, VWAP can be calculated as below:

 

wzor 4

 

wherePj is the average price level in each period.

 

Summary

 

VWAP is really simple indicator although it can be interpreted in various ways depending on goal and approach of the trader. It is mainly used by mutual and pension funds, but also by short-term traders. Aside from buying/selling small amount of shares, VWAP might be used as strategy for trading  huge number of shares without impacting the market. “Simplicity leads to popularity.”

 

References

  1. Berkowitz, S., D. Logue, and E. Noser. “The Total Cost of Transactions on the NYSE.”Journal of Finance,41 (1988), pp.97-112.
  2. H. Kent Baker, Greg Filbeck. “Portfolio Theory of Management” (2013) , pp.421
  3. Barry Johnson “Algorithmic & Trading DMA – An introduction to direct access trading strategies” (2010), pp. 123-126

 

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