Ashton Technology Group (fka ASTN)

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VWAP explained

Volume-Weighted Average Price (VWAP): definitions, opportunities and the future

In today’s fast moving financial landscape, acronyms replace descriptions with alarming speed. This is partly done in the interests of efficiency, and partly in the interests of mystification. So it is with VWAP. VWAP stands for ‘volume-weighted average price’ and represents the total value of shares traded in a particular stock on a given day, divided by the total volume of shares traded in that stock on that day. Calculation techniques vary: some will use data from all markets, some from just the primary market and may or may not adjust for resubmits and other error corrections. VWAP is a method of pricing transactions and also a benchmark to measure the efficiency of institutional trading or the performance of traders themselves. VWAP is drawing an increasing market following, so it is only fitting that there should be a VWAP article in this tenth edition of The Handbook of World Stock, Derivative and Commodity Exchanges.

As is often the case with financial innovations, VWAP is not welcomed by all market participants with unbridled enthusiasm. To quote Raymond Chandler, some people see innovations in the same light as they would see “a tarantula on an angel cake”. Or as one old trader once commented, “Do you know what’s been the main cause of early death in traders? Averaging!” Similar treatment has been given in the past to options (now a mainstream instrument even used by the day-trading general public), futures (now used as a daily hedging and positioning tool across the entire investment sector) and hedge funds (many mainstream fund managers have now established their own in-house ones). The answer to these objections is simple: different products have different advantages. It makes sense to use them when appropriate. VWAP is a useful additional tool, based on a simple but powerful idea. It has numerous implications that may not at first sight be obvious. Just as Henry Ford thought he was pioneering the mass-production of cars, but was in fact inventing the suburbs, VWAP requires more careful examination.

VWAP offers a smoothed price, incorporating both highs and lows and every trade in between into a single end-of-day price. This smoothing role was used by the London Stock Exchange. With the move from quote-driven to order-driven trading, closing prices were on occasion becoming unrepresentative of actual market conditions, thus eroding the Exchange’s reputation for accurate price formation. In response, the Exchange began calculating its closing prices using a VWAP methodology in December 1998. The Exchange calculates a VWAP based on the final ten minutes of trading and uses that VWAP as its closing price.

Executing VWAP trades: crossing and time-slicing compared
VWAP can be traded either on a crossing basis or a time-sliced basis. ‘Crossing’, as the name implies, means that an order is crossed between two counterparties and not executed with market-makers. No trade is executed in the marketplace. Because the buy and sell price of the two counterparties is identical, there is no market impact. Recent research by the Plexus Group quoted in Fortune Magazine found that a stock moves around 2% over the course of an extended institutional order – even more in the case of an illiquid stock or an especially large trade. After the order is filled, the price typically drifts back towards its pre-trade level. Although market impact is exceptionally difficult to measure, it is a very real trading cost. Crossing a VWAP deal presupposes a verifiable method of calculating VWAP. VWAP will not accurately be known until after the market closes, so both parties need to have confidence that they are using a ‘fair’ VWAP on which to base their crossing trade. For example, Ashton’s eVWAP™ is a fully automated crossing system that establishes the first and only US exchange calculated VWAP for US stocks. (Both the calculation and system are trademarked “eVWAP™”). The eVWAP™ calculation was subject to US Securities and Exchange Commission (SEC) scrutiny and incorporates trades reported on the US Consolidated Tape. It embraces regular way trades, late trades, re-transmits and corrections. It is calculated on a consistent and reliable basis day-in and day-out. Other US equity VWAPs are less regulated vendor calculations, which may be based on data from the primary market only for a particular stock. By using all market data, eVWAP™ assures a truer pricing assessment.

‘Time-slicing’ a VWAP order into the market is the alternative approach to crossing it. Time-slicing causes market impact as it involves actual trades into the market. A typical trading approach is to divide the trading day into so many time periods of the same length and trade the appropriate proportion of shares during each time period. One problem with this is that in addition to prices being volatile during the trading day, so is volume. Share volume is not evenly spread over the course of the day, with implications for the final VWAP figure at the end of the trading day. To compensate for this problem, time-slicers may use a “black box”. The black box may use an algorithm profiling a particular stock’s volume during each time period and simultaneously trade a corresponding amount of stock. Due to bid/ask spreads, market volatility and higher execution costs, time-slicing may result in inferior execution pricing than crossing orders at a “pure” VWAP calculation. Traditional agency brokers often offer VWAP executions on a best-efforts basis.

Quote vendors such as Bloomberg, Reuters and Bridge disseminate a dynamically updated VWAP throughout the trading day, enabling brokers slicing orders into the market to monitor their progress. This information can also be used by traders who have crossed a VWAP trade (with the price to be advised after the market has closed) to trade around that core position.

Electronic trading
Easy VWAP calculation and dissemination would not be readily available without the dramatic increases in affordable computing power. Financial trading is becoming inexorably more electronic and VWAP is part of this trend. In March 1999 the US SEC estimated that alternative trading systems (ATSs) executed approximately 20% of the total volume in Nasdaq securities and projected that this figure would triple by 2003. The shift to electronic trading is amply demonstrated in Europe by the rise of Deutsche Borse/Eurex and the conversion of previous hard-line open-outcry exchange Liffe to screen trading. The same pattern is repeated in the US, not only in the growth of ATSs and ECNs (electronic communication networks), but also in such developments as the proposed advent of the fully electronic options exchange, the International Stock Exchange.

Advantages of electronic crossing of VWAP orders
Automatic electronic systems are now frequently used to cross VWAP orders. For example, Ashton’s electronic crossing system for eVWAP™ is a completely anonymous pre-opening order-matching system for the execution of large-sized equity orders at the VWAP. The eVWAP™ system is the only VWAP crossing system sponsored by a registered US national exchange (the Philadelphia Stock Exchange). Following a morning order entry period, matches occur at 9.20 a.m. (US Eastern Time), with the final eVWAP™ calculated and reported to users at 4.20 p.m. each day. If the order cannot be crossed because of the absence of a counterbalancing order, the customer is notified – electronically and confidentially – before Wall Street opens, giving him time to issue instructions to operate in the market and avoid any opportunity cost. Alternatively, if an order is only part filled, the customer can focus on trading any residual in the market. Another advantage of electronic trading is that anonymity is guaranteed. With VWAP crossing systems that involve human interface, some information leakage inevitably occurs, with a corresponding impact on price. Lastly, the electronic execution of VWAP crossing orders is normally cheaper than the non-electronic version.

VWAP trading can also be used to reduce some of the burden from the trader. Traders are an expensive resource, and a busy trader may choose to execute some of his order flow via a dedicated VWAP system, leaving him to focus on areas where his time and skill may be better employed. Systems such as eVWAP™ provide traders, who may be under pressure to cut costs, with a way of adding value without making themselves redundant. In addition to its cost advantages, eVWAP™ also offers an additional trading tool and source of liquidity, which the trader can use to position himself against during the trading day.

VWAP users
A major trading consultant recently estimated that orders connected with VWAP pricing strategies constitute 12% of overall US equity trading volume. Today’s users of VWAP crossing systems are typically institutional fund managers and brokers. Fund managers can optimize portfolio returns by reducing transaction costs and guaranteeing consistent executions. Brokers can eliminate the need to hold lines of stock or concern themselves about liquidity and market timing once an electronic VWAP cross trade has been confirmed.

VWAP conceivably holds great allure for retail investors and retail brokers. As market volatility rises, making the decision when to execute a trade during the day difficult, brokers could simply offer a VWAP execution to their retail customers. Retail customers’ choice would certainly benefit if brokers offered to execute at “market,” “limit price” or “VWAP”. Indeed, Ashton has developed aggregation software so that a broker’s retail order flow can be bundled to meet the minimum eVWAP™ order size.

The acceptance of VWAP by institutions varies. Some large portfolio managers may consider VWAP to be the best trading benchmark, accurately reflecting the balance of supply and demand in a single price. The analogy can be used of the daily settlement prices for base metals determined by the supply and demand on the London Metal Exchange and widely used as daily international reference prices in the world of base metal trading. Pro-VWAP and anti-VWAP sentiments are evident in the media, but it can be argued that the need for VWAP crossing systems and other trading systems that reduce trading costs and market impact for large orders has never been clearer. For example, in the December 20 1999 edition of Financial Times Mandate, Barclays Global Investors claimed in new research that there was a limit to the value of assets an active manager could invest effectively.

BGI claimed that a point is reached at which the cost of trading starts to erode the value added by an active fund manager. Andrew Skirton, chief investment officer in Europe for BGI explained: “The key cost is market impact. The cost of investing more than doubles for a doubling of volume. As assets grow, it is harder to buy all your stocks at the market price.”

This conclusion was of course contested by active fund managers, who pointed to large active managers such as Schroders and Mercury who were still performing well. What does seem to be true is that – in the US, at least – the largest institutions are more likely than in the past to deal in large blocks of 250,000 shares or more. Such orders now account for 76% of their volume, up from 20% five years ago, according to Plexus Group, a trading research service.

VWAP also has relevance to another fashionable “issue” in the asset management business, that of indexing versus active management. Index trackers claim that they can often outperform active managers and also do it more cheaply. Active managers retort that most index trackers have not seen a prolonged bear market and that the value focused approach used by active managers enables them to use their superior analytical skill. VWAP, since it offers an average pricing product, is likely to appeal to index trackers (either overt or ‘closet’) who already try to minimise excess volatility in their returns by using an index. In a similar way, VWAP could be used to avoid buying at the daily highs and selling at the daily lows and provide a smoothed replicated index to fund managers, using VWAP transactions in the relevant stocks to mimic the index.

One specific group of fund managers who may be particularly interested in VWAP are market neutral funds, who trade pairs of stocks (long one, short the other) in the same sector, aiming to capture differential moves in the two stocks while avoiding market risk. Because they are buying and selling a position that they will in due course unwind, they are keen to trade at a benchmark price that does not include any bid-offer spread, a small but relentless cost for fund managers. A single definitive VWAP price has a strong appeal to them.

Lastly, corporations should consider embracing VWAP as a fair pricing practice in connection with their dividend reinvestment and corporate buyback programs. In this regard, corporations, and more importantly regulators, should readily see that VWAP is much less susceptible to manipulation than pricing large trades at “last sale” prices.

Disadvantages of VWAP
There are two sides to every argument. One of the advantages of VWAP is also one of its disadvantages: price smoothing. Just as some institutions will feel attracted to a price that removes the chance of hitting the day’s high (for the buyer) or the day’s low (for the seller), others will see VWAP as a quick way of giving up trading opportunities. As one trader remarked: “Use VWAP? We beat it!” Also, VWAP, unlike the price on a conventional stock trade, is only known with complete certainty at the end of the trading day.

VWAP is a broad measure derived from trades in the market and can be used as a convenient and common-sense benchmark for individual transactions, but there may be times when traders choose to execute a deal above the VWAP price. Looked at in purely VWAP terms this may be a “bad” trade, but motivational and size issues need to be considered as well. A trader pays for immediacy and may be pleased to execute a large conventional trade quickly, above the VWAP price, so as to avoid the price impact – difficult as it is to measure – of information leakage. (With an electronic VWAP crossing system, of course, information leakage does not occur, as there is no human intervention.)

The future: global VWAP standardisation and enhanced VWAP products
VWAP crossing systems are another way of bundling up trades in one price on one ticket. The discussion in this article has been wholly confined to daily VWAPs. As was pointed out in the opening comments, however, VWAP is a simple concept that can be applied to many different price universes. How about a closing hour VWAP, for example? Or an inter-day VWAP that could account for pricing a large block that could take days to execute in entirety? What about a VWAP for specific national and trans-national sectors? Trading on the first day of new issues is often extremely volatile: why not focus initial secondary trading of such issues on a VWAP pricing basis? So long as a consistent and comprehensive price feed is available, a VWAP is possible for all stocks. Finally, greater standardisation in systems and calculations relating to VWAP is likely. Ashton’s eVWAP™ is an example of this trend. With such standardisation taking place in the US, further global standardisation is likely. Ashton’s eVWAP™ system will soon be introduced in Canada and Hong Kong for VWAP trading of Canadian and Asian stocks. Due to time zone differences, many international money managers actively embrace VWAP pricing as a systematic and fair way of achieving best execution with less active oversight of the foreign broker entrusted with their orders.

Conclusion
VWAP is a price measure that is growing, particularly in the area of investment management. For VWAP to play a role in either trade execution or trade measurement, it needs to be transparent and have the confidence of its users.

VWAP is an institutional product that can be traded in either a time-slicing or crossing system mode. Crossing avoids market impact and bid/offer spreads. Electronic crossing facilities also offer a lower commission cost. Major quote vendors and Ashton’s eVWAP™ system provide a dynamically updated VWAP throughout the day.

The advantages of using an electronically crossed VWAP as a trading tool include total anonymity, a position to trade against, and pre-opening confirmation of trades. VWAP currently seems to be more widely used in the US than in Europe. It may be of particular interest to market-neutral funds and index trackers of all stripes.

Interest in VWAP has been encouraged by the rapid expansion in equity trading volumes and the growing role of institutions in the market. A study by Schwartz and Shapiro found that in 1965 block trades accounted for 3% of New York Stock Exchange trading volume. By 1992 this had risen to 54%. As institutions have become more involved, the costs incurred have fallen. Total trading costs are composed of explicit and implicit components. Explicit trading costs (e.g. commission, clearing and taxes) have fallen. In a 1995 study, Stoll found that commission costs in 1982 were 17.8 cents per share (0.58% of market value), more than double the 1992 figure. Implicit trading costs (e.g. price impact and the width of the bid-asked spread) are notoriously difficult to measure, but perhaps VWAP can be seen as an effort to reduce them. Recently published research shows that, more than ever before, UK fund managers are measuring their transaction costs. Emphasising this point is the fact that over 30 leading UK and continental European fund managers have now signed up to a new institutional crossing network, E-Crossnet. (The advantages of electronic crossing networks have been one of the themes of this article.) Readers of the financial press will also have noticed that investment banks have recently been aggressive investors in alternative trading systems (ATSs), which enable equity business to be transacted away from an exchange. Perhaps the hidden agenda that is common to all these initiatives is that market users are willing to sacrifice some immediacy of execution for a cost saving. A bit like VWAP, perhaps?

Ashton Technology Group, based in Philadelphia, is developing a family of on-line transaction and intelligent matching systems, using advanced telecommunication and computing technologies, together with data and information security technologies, to facilitate global financial transactions. Ashton’s proprietary transaction systems are made available to end users through networks, third parties, and the Internet. Ashton concentrates on the concept of developing alternative trading systems as unique adjuncts to established exchanges. Its US eVWAP™ trading system was launched as a facility of the Philadelphia Stock Exchange (PHLX) in August 1999.

Gary Delany can be contacted at [e-mail], telephone [phone].

Gary Delany, Vice President, Ashton Technology Group

http://www.exchange-handbook.co.uk/articles_story.cfm?id=5624