The main advantage of VWAP is its simplicity: It is both easy to compute and to understand.
Comparison against VWAP is also straightforward: An execution price better than VWAP indicates the security was traded better than the average weighted price, whereas a price worse than VWAP indicates the opposite. When VWAP is used as a benchmark, the goal of the trader is to equal or even beat the VWAP price of the securities in question. VWAP also encourages disciplined market participation while discouraging market timing (except in instances of guaranteed VWAP when the trader is rewarded for accurate market timing).
Broker-dealers favor VWAP as a benchmark. Again, because VWAP is an uncomplicated benchmark, most VWAP trading strategies are simple and relatively quick to execute. All broker-dealers now possess some form of algorithms run on computers to assist them or to trade automatically. VWAP's popularity has also reinforced certain volume patterns, making it an increasingly easy benchmark to attain. In general, it is difficult to look terrible against the VWAP price because every individual execution is included in the calculation. Therefore, the trader faces less risk of a poor execution vs. VWAP.
Ultimately, VWAP has several shortfalls that hinder its use as an effective benchmark. It increases the risk of opportunity cost; it does not measure impact cost; it's ineffective as a benchmark for less liquid orders; the results can be manipulated; and it emphasizes volume, not price.
Opportunity cost: A good VWAP execution will participate in line with market volumes in order to match the average price of the day or time period. The stock could be moving against you over this time period, but the pace of execution would remain unchanged. For example, a buy order will continue to be purchased in line with market volume even as its price moves up, increasing the average purchase price.
Impact cost: As a stock is affected by buying or selling, the VWAP is also affected. Therefore, the resulting VWAP price takes into account this impact. As an illustration, assume that a stock was sold over one day at an average price of $14.25 vs. a VWAP price of $14.24. At the outset, this execution looks very good against the VWAP — 1 cent per share (or seven basis points) better. However, if it were then revealed that the stock opened at $18 and closed at $13 per share, the quality of this execution would be called into question. VWAP cannot identify how much the stock's fall was affected by the selling activity that day.
Measurement: Trading has a greater influence on the VWAP price as the order size increases as a percent of daily volume, which typically is the case for illiquid securities. For example, suppose that a trader is the only seller of a stock on a particular day. The execution price will therefore equal the VWAP price, incorrectly indicating no trading costs. Therefore, VWAP is an especially poor measurement tool when liquidity is a factor since impact is not being measured.
Manipulation: The VWAP price of any security changes over the trading day as trades are printed in the market. Thus, a trader can increase control of the VWAP by increasing the pace of order execution and participating heavily in the market. This can push the VWAP price to a point where the trader's execution looks better, but it also leads directly to much higher market impact costs. Such gaming can more easily be done as described above with large orders or low liquidity stocks.
Volume, not price: A successful VWAP trade participates in proportion to market volumes across all prices, both high and low. Therefore price is of secondary importance to volume. To fully understand VWAP, it is vital to see how a trader attains VWAP.