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I have some questions on (volume weighted average price):

1) I understand that it gives the average trade price of an asset for a specific time period but why is it important to know this when executing trades(specifically in the context of algo. trading)?

2) How would one base their trade execution decisions on VWAP?(Please would you explain it for an order to buy and an for an order to sell)

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VWAP is used a few different ways. I'll mention two.

  1. Investors who trade a lot of volume have specialized traders acting on their behalf that spread the trade throughout the day. In fact, these traders often attempt to do most of the trades during times of higher liquidity (when volume is high) so as to avoid affecting the price. In principle, if a trader is skilled, then the average price that trader gets for you will be better than what the market in general got during that time period. What did the market get on average? The VWAP. So at the end of the trading period, you can look at the weighted average price you got and the weighted average price the market got and evaluate the quality of your trader.
  2. Technical traders may use VWAP as a way to smooth out the "average price" over a time period. The price on most securities jumps up and down and awful lot during the day. However, some of those moves represent a lot of trades and others very few. Over a particular time period, you can continuously compute the cumulative weighted average price people are getting. If you have a technical trading rule in mind, like "buy only when the price is below the average for the day," then you might trade when the price is below the VWAP calculated from the beginning of the day until now.

In general the VWAP is just another way of saying "average price," where the average is weighted by how much has actually traded at each price. This allows you to compare a price to what others have gotten over a time period, as opposed to comparing to non-weighted average, which may give too much weight to prices at which very few people actually traded.

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