Here’s a step-by-step explanation of TWAP:​

1. Understand the Purpose of TWAP

• Objective: TWAP is designed to minimize the impact of large trades by spreading them out evenly over time.
• Why Use TWAP?
  • Reduce Market Impact: Large trades can move the market price if executed all at once. TWAP ensures the trade is executed gradually to avoid pushing the price up (for buy orders) or down (for sell orders).
  • Execution Efficiency: TWAP helps achieve an average execution price over a given time period, providing fairer pricing for institutional traders.
  • Benchmarking: TWAP is often used as a benchmark to compare the actual execution price to a time-based price.

2. Determine the Time Interval and Trade Quantity

• Objective: Set the total amount of the asset to be traded and divide it into smaller quantities to execute over the chosen time period.
• Parameters to Define:
  • Total Quantity: The total amount of the asset you want to buy or sell.
  • Time Period: The total time duration during which you want the trade to be executed (e.g., 1 hour, 1 day).
  • Interval: The time between each smaller trade execution (e.g., every minute, every 5 minutes).
• Example:
  • You want to buy 10,000 shares of a stock.
  • You choose to spread the order over 1 hour.
  • The trade will be executed in 60 intervals (one trade per minute).

3. Calculate the Size of Each Trade

• Objective: Divide the total quantity to be traded into smaller orders based on the chosen interval.
• Formula: $$\text{<span style="line-height:1.5em;"><span style="font-family:arial,helvetica,sans-serif;">Size of Each Trade</span></span>}<span\; style="line-height:1.5em;"><span\; style="font-family:arial,helvetica,sans-serif;">=</span></span>\frac{\text{<span style="line-height:1.5em;"><span style="font-family:arial,helvetica,sans-serif;">Total Quantity</span></span>}}{\text{<span style="line-height:1.5em;"><span style="font-family:arial,helvetica,sans-serif;">Number of Intervals</span></span>}}$$Size of Each Trade=Number of IntervalsTotal Quantity​
  • For example, if you want to buy 10,000 shares over 1 hour and you plan to execute one trade per minute (60 trades), the size of each trade would be:

$$\frac{10,000 \text{ shares}}{60 \text{ intervals}} = 166.67 \text{ shares per trade}$$

• 60 intervals10,000 shares​=166.67 shares per trade (Usually rounded to the nearest whole number, e.g., 167 shares).

4. Execute Trades at Regular Intervals

• Objective: Ensure that trades are executed at regular intervals (e.g., every minute, every 5 minutes) throughout the time period.
• Steps:
  • Use an algorithm or manually place trades at the set intervals.
  • Each trade will execute the same number of shares at the current market price.
  • If you’re using an automated system, it will handle this process for you.

5. Monitor Execution Prices Over Time

• Objective: Keep track of the price at which each small trade is executed.
• Why Monitor?
  • It helps ensure that the trades are spread evenly and the execution price remains stable.
  • Monitoring allows you to compare the actual execution price with the expected TWAP.

6. Calculate the Average Execution Price

• Objective: At the end of the trading period, calculate the average price at which the trades were executed.
• Formula for Average Execution Price: $$\text{TWAP} = \frac{\sum \text{Execution Price}}{\text{Number of Trades}}$$TWAP=Number of Trades∑Execution Price​
  • For example, if you executed 5 trades with prices of $100, $102, $101, $103, and $99, the TWAP would be:

$$\text{TWAP} = \frac{100 + 102 + 101 + 103 + 99}{5} = 101$$

• TWAP=5100+102+101+103+99​=101
• This gives you the time-weighted average price of the asset during the specified time period.

7. Use TWAP as a Benchmark

• Objective: Compare the TWAP to the overall market price to assess the quality of your trade execution.
• Why Benchmark?
  • TWAP serves as a reference point for measuring how well the trades performed against the average market price during that time.
  • Institutions often aim to execute trades as close to or below TWAP to demonstrate that they did not negatively affect the market price.

8. Adjust for Market Conditions (Optional)

• Objective: Modify your TWAP strategy in response to market conditions (e.g., high volatility or low liquidity).
• Why Adjust?
  • If the market is volatile, you may want to adjust the size of each trade or the time intervals to minimize slippage or adverse price movement.
  • In illiquid markets, spreading trades too thin could result in poor execution prices, so monitoring liquidity is important.

9. Combine TWAP with Other Strategies

• Objective: Enhance your TWAP execution by using it alongside other indicators or strategies.
• Examples:
  • VWAP + TWAP: Use VWAP to gauge the volume-weighted price alongside TWAP to compare time-based and volume-based benchmarks.
  • Momentum Indicators: If you notice momentum building, you might want to adjust your TWAP strategy to place larger trades during favorable price movements.

Example of TWAP in Practice:

Let’s say a trader needs to buy 5,000 shares of a stock over 2 hours (120 minutes). They decide to execute trades every 10 minutes, leading to 12 trades in total.

1. Total Quantity: 5,000 shares
2. Number of Intervals: 120 minutes / 10 minutes per trade = 12 intervals
3. Size of Each Trade: $$\frac{5,000 \text{ shares}}{12 \text{ intervals}} = 416.67 \text{ shares per trade}$$12 intervals5,000 shares​=416.67 shares per trade (Usually rounded to 417 shares).

At each 10-minute interval, the trader buys 417 shares at the current market price. After 12 trades, the trader calculates the average price they paid, which would be their TWAP.

Key Points to Remember:

• TWAP as a Benchmark: TWAP is primarily used by institutional traders as a time-based execution benchmark.
• Steady Execution: It focuses on placing trades at regular intervals, ensuring that the trader doesn’t significantly impact the market price.
• Use for Large Orders: TWAP is especially useful when executing large orders that could otherwise cause significant market slippage if placed all at once.
• Execution Flexibility: TWAP can be combined with other trading strategies, and it can be adjusted based on changing market conditions.