Why trading a VWAP is not as easy as it looks

Yesterday we did a small introduction to VWAP trading, what it is, how and when it is used. The truth is that despite being a simple concept, it is one of the most used ways to trade for most institutional clients, it gives them a good way to benchmark the execution that was done in order to determine if the execution was well done and if the VWAP algorithm is doing its job.

If you remember yesterday’s example, it implied purchasing about 2,500 shares of Apple every minute during 5 days. Easy enough right? Wrong. Someone one did a VWAP with those parameters would get killed. Why? Because of high frequency traders. If one of these algos checked the markets, they would see a buyer coming in with a buy 2500 every minute for days. Believe me, it would take advantage. How?

It’s all a matter of speed. Here is an example. If I know that a specific investor will be buying shares of Apple every minute, I will generally buy some Apple shares maybe 0.1 seconds prior to that and then resell them right after the investor has made his purchase. What this would do would be drive up the price for a few milliseconds and then bring it down.

The VWAP algorithm would end up paying a few penny fractions more on each execution while the HFT would collect those fractions. It might be small but over 3 million shares it adds up. This is also why many traders argue that High Frequency Traders do not only bring benefits such a liquidity and volume but that they also cost investors that execute similar strategies.

There are hundreds of people that spend their days trying to figure out how to hide such strategies, how to execute better, while on the other side HFT’s try to find the strategies and profit from them. It’s an exciting game for all participants no doubt. Here are some of the strategies that are used to “hide” VWAP strategies:

-Changing the order size.. obviously, an order of 2500 shares every minute would be easy to detect
-Executing at more infrequent times (every minute is too easy to spot)
-Executing on different stock exchanges

There are so many different ways to improve execution  of a simple strategy such as the VWAP but the strategies must be improved continuously as HFT’s become better at detecting the strategies and “fronting them”.

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