Best of Dragonfly Capital: Day Traders, You Need to Understand VWAP

While I am on vacation I have combed through the archives to find the best articles that also stand the test of time. Here is today’s selection from October 2013:

Ask a quantitative analyst or technician what VWAP is and they will rocket back a response. Volume Weighted Average Price. It is truly as simple as taking every trade and summing up the product of all shares that trade at the price they trade and then dividing by the total number of shares. Pretty simple right? So the VWAP on the day is then a measure of the weighted average price over the day. If you put a point on a chart that showed where the 147 million shares of Facebook, $FB, traded Wednesday, to get a sense of where there will be price memory, this would be that one point.


The chart above has been stripped bare to show how the VWAP moved over the day Wednesday for Facebook. Starting out with price very tight to it then oscillating over and under. Traders will use VWAP to determine whether the price is getting extended from the mean and might revert back towards it. A type of overbought and oversold indicator.

But there is another side of VWAP that you need to understand if you are a day trader that is the root cause of this movement. As a day trader in you can use other indicators to determine if the price is good to buy or hold or sell. But what if you are David Einhorn or Carl Icahn or even Bill Ackman and you need top buy 10 or 20 million shares to get to your position size. You cannot just bid all at once or offer 1/4 backed up by 3 other orders. That will impact the stock price and it will always be moving against you. These behemoths instead pay someone to trade into the position for them. Using Facebook as an example, if Carl wanted 10 million shares he would see that is over 13% of the 90 day average daily volume. He needs to spread that out. So he will ask his broker, maybe my friend Sal Arnuk at Themis Trading to buy him 10 million shares over the day at the VWAP. He may also ask that he is never more that 15% of the volume to be safe. Sal probably has an algo for this (or a broker that he will pass it to that does). Their algo has historical minute by minute (maybe even thinner sliced) historical volume profiles that is will use to buy 100 to 500 shares at a time constantly through out the day. If the volume profile fits the historical then the algo will produce a VWAP fill price for the order and Carl is happy.

No big deal right? Now is the important part. Have you ever heard that so and so stock is the darling of all the hedge funds? How do you think that happens? It is not an accident. The hedge funds get ideas from their brokers. And the brokers are selling the same idea to every hedge fund. Even if it is not their idea but they heard about it from another hedge fund they are gonna sell it to everyone they know. Which brings me back to you as a lowly day trader swinging 1000 or 10000 shares of Facebook around. If you get in front of one of these freight train stocks that all the hedge funds are trying to get into or out of, you can end up being a splat of blood on your screen if you are not aware of how this works and acting in a counter trend. Have you noticed how volume is heavier at the beginning of the day and then can go crazy at the end of the day. What will happen if hedge funds are trying to sell 10 million shares less than 15% of the volume and the volume is light? The broker tells the fund it is running soft and then the fund says, ramp it up. More selling or buying. At 3:45 and with only 80% of the order done they tell the broker “Just f’ng get me done!” Now you are vapor if leaning the wrong way.

I used hedge funds in this example but it is just as likely to be Vanguard or Fidelity acting for one of their monster mutual funds. Have a better understanding of what you are up against now?

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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