There are two main reasons why traders
execute orders using a VWAP trading
strategy. First, a VWAP strategy is
the trading strategy that minimizes
market impact cost. Traders executing
orders utilizing VWAP strategies are
interested in participating with
market volumes so to cause the least
disruption to the supply-demand
imbalance in each period. Second, for
many traders their execution
performance is measured against the
VWAP benchmark. An average execution
price more favorable than the VWAP
price benchmark is considered
high-quality performance while an
average execution price less favorable
than the VWAP benchmark is considered
But, when it comes to backtesting, the market impact is thus assumed to be zero. One is assuming he does not affect the market as the VWAP benchmark price stays untouched. So how can one backtest his VWAP strategy effectively and more realistically?
This isn't exclusive to VWAP; any assumed trade price (NBBO, Arrival Price, etc) has the same vulnerabilities. Many shops often lump market impact with slippage and transaction costs when modeling the difference between the ideal price and the realized price.
To model the impact during a backtest for a given trade price, assess a penalty:
This penalty can be fixed (X basis points added to each buy price) or it can be variable (Y percentage extra cost for each buy price). One could use a combination of both.
For variable penalties, the percentage can be a single number for all trading activity, or it can grow quadratically with respect to the size of the trade. An aggressive penalty models removing liquidity in the order book.
To be really swanky, one could have a different penalty for each unique instrument in the portfolio.
Many shops consider their transaction-cost models to be very proprietary. It takes a lot of post-trade analysis to determine proper values for X and Y.
To get a feel for it think about an extreme scenario. Suppose I have an order to buy $100bln VWAP in IBM over the course of one day. My "cost" relative to VWAP will be near zero, b/c I will be on the buy side of every trade that day. However, my market impact will be extremely high b/c IBM will fall like a rock the next day, leaving me with huge losses. This is your true cost.
The bottom line is trading will create impact - that is part of your cost. It is increasing in increasing trade size and decreasing in increasing liquidity of the asset. VWAP merely spreads the trade out to reduce the impact. Look at Almgren and Chriss for a discussion of transaction cost functions, or talk to the provider of your VWAP algo for more details.