Time-Weighted Average Price (TWAP): What It Is and How It Works

What is TWAP?

Time-Weighted Average Price, or TWAP, is a strategy used to split a large order into smaller orders without affecting the market price.

TWAP orders are a strategy that we use to execute orders within a specified time period, reducing the risk of front-running and market volatility.

Why Do We Need to Use TWAP?

TWAP is used to accumulate shares or sell them in smaller orders over specific timeframes. This helps reduce the market impact from moving big orders.

Market makers trade millions of shares a day at the current price and continuously either place or fill orders, which cause liquidity to fluctuate. During this period, it might be difficult for us to place orders at our desired price. That's why we need TWAP to help execute orders even when the market liquidity is limited.

How Does the TWAP Strategy Work?

Here are the factions you need to consider for using the TWAP strategy: 

• The time period should be long enough to minimize your orders

• Decide the size of an order because it incurs transaction fees and affects market moves.

• High liquidity is best for large orders, as lower liquidity may be impacted by the price movements.

• Execute orders quickly during High market volatility to minimize the risk.

However, different trading platforms have different details for orders, time periods, order sizes, etc.

The strategy is most commonly used to combine with trend trading.

• If you would like to "Buy", the price should be over TWAP

• If you would like to "Sell", the price should be under TWAP

You can combine this strategy with other indicators or a price-action strategy to avoid false signals caused by market volatility.

What is the TWAP Formula?

We will use the below TWAP formula to calculate a more accurate average price on traded volume.

TWAP = (P1 + P2 + P3 + ... +Pn)/Pi

How is TWAP Calculated?

Let's bring an example to make it easier for you.

• The price every 1 minute: 200, 202, 198, 192

• Time period: 4 minutes

TWAP = (200 + 202 + 198 + 192)/4

TWAP = 198

Answer: 198 represents the Time-Weighted Average Price every 4 minutes equally.

What is an Example of a TWAP Order?

If you would like to purchase 1,000 shares every 5 minutes for 1 hour (= 60 minutes), you can find the average price across intervals below:

• 5-minute intervals in 1 hour = 12 intervals

• 1,000 shares x 12 intervals = 12,000 shares total

• Purchase every 5 minutes each

• The broker executes 1,000 shares at intervals and at the market price

Let's say the market price is 201 +199 +202 + 185 + 204 + 198 + 203 + 189 + 205 + 222 + 197 + 190

It means you would pay 200$ per share.

Example of TWAP Strategy in Stock Trading?

First, you need to understand why TWAP works best for stock trading?

Because it's a traditional trading strategy used by market makers, banks, and institutions across different markets, but not effectively in Crypto.

Here's an example in stock market

• Big investors, like Institutional investors, use TWAP to trade quietly so market participants don't see the large orders.

• The algorithm uses TWAP to keep the market price steady throughout the day by creating volume without causing price fluctuations or drops.

TWAP vs VWP: Which One is Better?

Many traders get confused about TWAP vs. VWP and which one to use. Let's have a look their comparison below:

TWAP VS Other Order Types

TWAP order is unique and different from other order types because it's a strategy that helps you execute at a desired price over a time period.

However, for traders who are curious about the difference between TWAP market orders and limit orders, let's continue to read the details below

• Market Orders: This order will be executed at the current price immediately. A large order might also cause price spikes.

• Limit Orders: We set this order at a specific price that you would like to buy or sell, but it won't execute immediately if the market doesn't reach the price

• TWAP trading: Traders and investors use TWAP to minimize market impact, execute orders over a specific time period, and achieve an average price.

Common Mistakes in Using TWAP

TWAP is one of the powerful strategies for traders and investors. However, there are some mistakes that you should avoid when using TWAP

• TWAP doesn't account for trading volume; instead, it focuses on market liquidity.

• TWAP works best at medium-sized orders in a stable market.

• Always check market volatility and new events before purchase.

• You need to check market conditions and the bid-ask spread, and set a stop loss.

What is TWAP Risk Management?

TWAP helps you manage risk by allowing you to modify upcoming orders at the desired price, but there are some risk management factors you shouldn't ignore.

• You need to always monitor market conditions, as this is not automatic.

• Always set a stop-loss when you enter the market alongside TWAP

• Set the maximum price always at the minimum of selling and the maximum of buying to prevent executing trades at the worst price

• Before submitting an order using the TWAP strategy, you should review it again to ensure everything is accurate.

Pros and Cons of Using TWAP

Conclusion

The TWAP trading strategy is a tool for minimizing large orders to avoid the market impact and help you execute at the desired price over a time period. Also, it helps you reduce price fluctuations, maintaining price stability so you can trade effectively in low-liquidity markets.

However, you need to understand the market and risk management to combine with this Time-Weighted Average Price strategy to make sure it works effectively. TWAP works best when used alongside price action and trend trading to avoid false signals.