Tuesday, April 8, 2014

vwap execution chasing the wrong signal - my guess

A vwap algo starts with a "model profile", which tells us each hour (or minute) of the trading day typically experiences how many percent of the total daily volume.

Then the algo tries to execute according to the model profile, executing 10% in the first hour. The actual market profile may show a spike in the second hour. Suppose 2nd hour usually gets below half of first hour according to the model profile, but we see it's going to more than double the first hour, because the past 5 minutes show a very high spike in volume.

Question is, should we increase our trade rate? I guess there's reason to do so. When the volume spikes, we should trade bigger chunks so as to let the spike "mask and absorb" our market impact. If we don't capture this spike, then 2nd hour might end up being 80% of daily volume, but we only put in 4% our quantity, so our remaining quantity would cause market impact.

However, it's also possible to chase the wrong signal. The spike might cause a large rise or (more likely in realistic panic-prone markets) drop in price, which could reverse soon. Suppose we are selling a big quantity and the spike causes a big drop. Our active participation would further deepen the drop. We might do better to patiently wait for a reversal.

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New York (Time Square), NY, United States
http://www.linkedin.com/in/tanbin