Moving averages are among the most popular tools for all forms of trading.
Day traders and swing traders use them to track the average price of financial instruments over a given time period as part of their trading strategies.
Traders rely on moving averages to provide an overview of average price movement and filter out market noise.
By weighting the average based on important factors such as how recently the price change was made or the amount of volume that was traded, one can find patterns in price action.
In this post, we will focus on the time weighted average price indicator, or TWAP for short, and learn how traders can use it. We are also going to examine the TWAP calculation process.
Let’s dive in!
What is the Time Weighted Average Price (TWAP)?
The time weighted average price is a trading indicator based on weighted average price that shows the average price of an instrument share as it rises and falls during a given time period.
Basically, it is the average price of a stock over a specified period of time.
Unlike the volume weighed average price (VWAP) indicator, the TWAP does not take into consideration the number of shares traded at each price point measured. You can calculate TWAP for any specified time duration.
The trader first identifies the opening, closing, high and low prices for the stock on a given day and then finds the average of those daily prices for each day he tracks the stock.
To get the TWAP, the trader takes the average of the individual daily averages.
Here is an example of the TWAP on a 30 minute crude oil chart is shown above. The displays the TWAP, which acts as resistance and then support.
This indicator is calculated for executing large trade orders and its purpose is to minimize the market impact on basket orders. Using the TWAP value, you can split a large order into a few small orders valued at the TWAP price because it is the most important value.
Once each order is executed there will be a delay for (duration / order count) minutes.
For example, if duration is 30 minutes, and the order count is 6, then there will be a (30 / 6) = 5 minute delay between each order.
Generally, traders do this to avoid letting a huge order suddenly increase the value of a given instrument in the market.
How TWAP is Calculated
The time weighted average price indicator is calculated by taking average of Open, High, Low and Close price of each bar, and then calculating the average of these averages for ‘n’ number of periods.
For example, if you want the TWAP value for 20 periods, this is what you will do:
- Take average of Open, High, Low and Close values of each individual 20 bars. Say it y1,y2,y3…..y20
- Take average of y1 to y20. TWAP= (y1+y2+y3………..+y20)/20
As you can see, TWAP calculation does not require involve any complex mathematical equations. The calculation is even easier to grasp than VWAP.
TWAP Example
Let us now take a look at an example of TWAP.
Suppose a trader wants to track the TWAP of a share of ABC stock for 14 trading days.
On the first day, shares of XYZ open at 12, close at 16, reach a high of 17 and a low of 15. The daily average for the first day is (12+16+17+15)/4, or 15.
The trader repeats this process every day for 14 days, then averages the results to find the 14-day TWAP. The trading strategy is most useful when you want to spread out trades evenly over a given time period.
Why is TWAP Important?
There are several reasons why TWAP matters.
The indicator gives more weighting to the most recent price changes, while still taking into consideration past data. It is a great trading tool when combined with other indicators, to help determine a trend.
Here are some of the benefits it can offer:
- TWAP is an excellent solution for executing orders over a period of time in smaller parts instead of a single large order in one go. For example, if your trading algorithm gives you a buy signal and you want to buy 10,000 shares of a stock. You can reduce the impact on the market with the option to slicing this order in small orders, say, 250 or 500 each hour/minute.
- It allows traders to distribute their orders throughout the day without having their positions known to rival traders or disturbing price in the market.
- It is great for people who do high-frequency trading or other forms of quantitative trading such as algorithmic trading.
- It minimizes impact costs and is a simple indicator to use as part of your research.
- It does not put affect market price with the execution of the entire big order.
How TWAP can be applied to trading
TWAP is most commonly used to distribute big orders throughout the trading day.
For example, you want to buy 100,000 Tesla (NASDAQ: TSLA) shares. Placing one big order would most likely have an impact on the market causing the price to go up.
To avoid this, you can set a time period over which you want to buy the shares. The TWAP indicator will help you spread out the large order into smaller orders and execute them over the set time period.
However, traders are advised to use the TWAP on securities that do not have any volume profile available or over short periods, since there is still the possibility of trading during a period of low liquidity where your split-up orders would still weigh on the market.
Bottom Line
The TWAP trading strategy and indicator is a helpful tool that traders use to enter and exit a trade. This simple trading strategy allows traders to compare stock price points over time.
It is closely linked to the volume-weighted average price, which shows the average price at which a security has traded over time, weighted against its trading volume. Many traders use this indicator along with candlesticks on their trading charts.
While mastering this indicator won’t happen overnight, it is indeed worth it, given how vital it is for day traders to have a clear picture and the best conditions to make an informed decision.
And the TWAP offers just that – it can enhance your trading strategy and simplify decision-making process.