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You have probably heard me mention the term VWAP in the nightly BTS video reviews I upload to YouTube. Yet, it is a term that seems to elude people because there is little worthwhile information about it out there.
Sure, there are plenty of “trading” videos on YouTube about VWAP that mind numbingly regurgitate the same information. And there are also hundreds of websites and forums that essentially just repeat the same message, just in a different media.
In short, there are very few worthwhile sources regarding VWAP. I am not sure why. Perhaps it is because people believe it is too complex, or they can’t relate to the information they are being told. Whichever it is, I will attempt to turn VWAP into a non-complex, digestible format for you to absorb which will hopefully be useful in your trading.
While popular images of Wall Street often depict heroic traders boldly making large gambles on just their gut feel, most of the trading is considerably more technical and constrained. The constraints often originate from a complex combination of business, regulatory and institutional matters, which result in certain types of standard trading strategies or criteria that attract algorithmic analysis.
One of the most common activities in modern financial markets is known as Volume Weighted Average Price, or in short VWAP.
Simply put, the VWAP of a stock or future over a specified market period is simply this; the average price paid per share or contract during a defined period. To frame another way, it is the price of each transaction in the market as weighted by its volume.
In VWAP trading, traders attempt to buy or sell a fixed number of shares at a price that closely tracks or is better than VWAP. Very large institutional trades constitute one of the main motivations behind VWAP activity. In other words, the institutions are using VWAP to assess or benchmark how well their traders are executing transactions. Let’s look at a quick example and note, you may need to read this a few times to absorb it.
Suppose a very large mutual fund holds 3% of the outstanding shares in Apple [AAPL]. The fund manager knows this percentage is a huge fraction of the shares and would like to reduce the funds exposure from 3% to 2% over a period of a month. The reason the fund manager wants to reduce his exposure to Apple is irrelevant in this example, but in some cases, they might be forced to because of the fund’s own regulations or other reasons such as a rebalancing of the mutual fund portfolio.
Typically, a fund manager would be unqualified to sell such a large quantity of shares in the open market. So, they are going to need help. And that help comes in the form of a licensed professional broker. The broker has the knowhow to intelligently break the trades up over the timeframe required by the mutual fund manager, and possibly over multiple exchanges in order to minimize the market impact of such a sizable transaction. Consequently, the fund manager would approach brokerages for help in selling the 1%.
The brokerage will typically relieve the fund manager’s problem by simply buying the shares directly from the fund manager, with the intent to sell them later. The important question is; what price should the brokerage pay the fund manager for the shares? Do you have any ideas?
Paying the price on the day of the sale would be too risky for the brokerage, as they need to sell the shares themselves over an extended period. Events beyond their control (such as poor iPhone sales, or a change in leadership) could cause the price to fall dramatically. The typical answer is that the brokerage offers to buy the shares from the fund manager at a per-share price tied to the VWAP over some future period
In this example, the brokerage might offer to buy the 1% at a per share price of the coming month’s VWAP minus 1 cent. The brokerage now has a very tidy task; if they manage to sell the shares themselves over the next month in a manner that exactly matches the VWAP, a penny per share is earned in profits as agreed with the mutual fund manager.
Perfect. The mutual fund manager is happy, the brokerage is ecstatic, and they can all go out for a steak dinner.
But wait, what if the broker can beat VWAP by a penny and make two cents per share instead of one? Sure, this is still a small margin, but with high-volume, profits can be extremely lucrative. Therefore, now having successfully beaten VWAP, the mutual fund manager is likely to repeat his business with the broker and the cycle repeats.
The importance of the VWAP has led to many automated VWAP trading algorithms. Every major brokerage has an execution pattern related to VWAP. But what do we mean by “beating VWAP”? Put simply, it means achieving a better price relative to VWAP itself. I.E. buying below VWAP or selling above VWAP.
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