VWAP vs TWAP: Key Differences in Trading Strategies

Everyone is turning towards algorithmic trading. Execution is extremely important to have good returns from algorithmic trading. Two important execution strategies used are VWAP (Volume Weighted Average Price) and TWAP (Time Weighted Average Price). It is important to note that here we are not discussing trading indicators. In fact, these are different mechanisms to execute the algorithms so that the traders can buy and sell large orders more efficiently without disturbing the market.

Both VWAP and TWAP aim to minimise slippage, reduce market impact, and improve the overall execution price. However, they use very different methodologies to do so. So, whether you are a retail trader exploring algorithmic tools or an institutional desk managing large volumes, the complete understanding of VWAP and TWAP is essential so that you can make better trade executions. 

What is VWAP (Volume Weighted Average Price)?

VWAP or Volume Weighted Average Price is one of the most popular trading execution mechanisms to reduce slippage. The aim of VWAP is to reflect the average price at which a security has traded throughout the day, weighted by volume. This value gives traders a sense of understanding of the average true price that has been traded in the market today. This also means that this is the price at which other traders have paid or received for a stock.

While VWAP is considered a technical indicator, it is widely used by smart money and institutional investors to trade large orders without distorting the market. The basic principle is that when the execution price is close to or better than the VWAP, it suggests the order was executed efficiently.

The formula of VWAP is,

VWAP = ∑(Price×Volume)​ / ∑(Volume)

Where:

• Price = Typical price at each interval (usually average of high, low, and close)
• Volume = Number of shares traded at each interval

VWAP is an indicator which is calculated continuously throughout the trading day. For the calculation of VWAP, we can calculate the typical price = (High + Low + Close) / 3. Then we will multiply this by the volume traded during that time interval. Finally, we will keep taking the sum of this (price × volume) across intervals, and divide by the cumulative volume.

Here are some considerations while using VWAP. As a buyer, if the trader is able to buy below VWAP, then he has been able to get a better price than the average market participant. On the other hand, as a seller, selling above VWAP is seen as positive execution. And for institutions, VWAP-based algos help split large orders over time to avoid price disruption and ensure fair pricing.

What is TWAP (Time Weighted Average Price)

TWAP or Time Weighted Average Price is the next execution strategy that spreads an order out evenly over a specified time period. TWAP thus only focuses on time intervals and does not take into account the volume traded during that time.

The main aim of TWAP is similar to VWAP. It is to minimise the impact of a large order on the market by executing small slices at regular intervals. TWAP is usually preferred in those instruments which have low liquidity. 

The formula of TWAP is,

TWAP = ∑(Price at each interval)/Number of intervals

 Where:

• The price at each interval is usually the last traded price at that timestamp
• All intervals are equally weighted (e.g., every 1 minute)

Let us take an example.

Imagine we want to buy 10,000 shares of a stock over 5 hours.

A simple TWAP strategy would break this into equal-sized chunks and execute them at a fixed time interval.

So, if we want to trade every 5 minutes, there will be a total of 5 hours x 60/5 = 60 chunks. So, after every 5 minutes, we will place 10000/60 = 167 trades. 

It doesn’t try to “outsmart” the market with timing or volume shifts. Instead, it executes like clockwork, which is exactly what some traders want for stealth or control.

TWAP is especially useful for institutional and algorithmic traders because it offers a deterministic, volume-agnostic execution path. Also, for illiquid stocks, TWAP can help avoid dumping of large orders, which can move a thin order book.

Key Differences Between VWAP and TWAP

While both TWAP and VWAP help in getting better execution, here are the major differences between them:

When Should You Use VWAP?

VWAP is used when the instrument being traded is liquid and we want to benchmark our execution against the market average. It is mostly used when we don’t want to move the price too much, but still want to benefit from favourable volume conditions. Some of the ideal scenarios when VWAP can be used are:

• High-volume stocks or ETFS: More volume essentially means that there are more opportunities to blend into the market activity.
• Benchmarking performance: Mostly for institutional desks, whether they want to evaluate different strategies and algorithms
• Minimising slippage: The main aim is to take large orders while getting minimal slippage
• Passive order execution: There is no rush to take the order quickly

When Should You Use TWAP?

TWAP is best suited when the primary goal is to minimise market impact and execute trades evenly over time. That means it is especially useful in low-liquidity markets or when dealing with large orders that might distort prices if executed all at once. Some of the ideal scenarios when TWAP can be used are:

• Low volume or illiquid assets: Usually, large orders can have a lot of impact on illiquid stocks, so TWAP spreads the execution to avoid the impact cost.
• Minimise signal risk: Many algorithmic traders do not want to reveal their strategy by placing large orders. TWAP can help avoid attention to large trades.
• Volatility-neutral execution: TWAP can also help in avoiding overreaction to sudden spikes in trading volume. This makes TWAP ideal when the goal is neutrality over precision.

VWAP vs TWAP: Which One is Better?

The answer depends on your trading objective, market conditions, and liquidity of the asset. Here is a summary of which to choose based on different conditions:

Common Mistakes While Using VWAP/TWAP

We have discussed that both TWAP and VWAP are extremely powerful execution strategies. However, misusing them can actually lead to more slippage and signalling risks. Here are the common mistakes that traders should avoid while using VWAP:

• Trading at the End of Day Using VWAP: VWAP should mostly be used as an intraday guide. Because there is high volume at the end of the day, VWAP can get skewed, leading to trades that don’t reflect true average price dynamics.
• Using VWAP in Illiquid Stocks: As already mentioned earlier, if the instrument being traded is illiquid, VWAP-based orders may not execute properly or may trigger unfavourable prices.
• Ignoring Market Conditions: It is important to appreciate that VWAP thrives in normal market conditions. So if a trader executes a VWAP strategy during high volatility, news events, or sudden trend shifts, the results might not be profitable.

Similarly, some mistakes that the traders should avoid while using TWAP are:

• Blindly Slicing Orders by Time: TWAP does not take into account the volume of the instrument being traded. So, if the asset is extremely illiquid and the time interval is small, executing the same size may cause slippage if the market is thin.
• Not Accounting for News or Events: If you use TWAP during volatile periods (like earnings announcements), it might trade against strong trends.
• Overuse in High-Volume Assets: TWAP works best when the volumes are moderate. So, if we execute the TWAP strategy in highly liquid stocks, it might not give optimal results, which can be achieved by deploying VWAP instead.
• No Dynamic Adjustment: Basic TWAP doesn’t react to spreads or price movement. Hence, it continues execution mechanically, even in poor conditions.

Conclusion

As a trader, especially doing algorithmic trading, both VWAP and TWAP are essential tools to increase profitability. However, they serve different purposes. VWAP excels in high-liquidity environments where matching or beating the average market price is the goal. TWAP, on the other hand, shines when stealth, neutrality, or illiquid assets are involved, offering more control over time-based execution. The trader must carefully choose between them to best align based on the execution objective, asset characteristics, and market environment.