Algo Trading: Understanding Order Types, Order Books, and VWAP/TWAP Strategies

In today’s fast-paced financial markets, algorithmic trading can give you a serious edge—if you know how to use it right. Whether you’re just getting started or aiming to sharpen your strategies, one key thing you need to master is how different types of orders impact the market.  

By understanding how these orders interact within the order book, you can start building smarter trading algorithms that minimise market impact. Let’s break down how different order types and strategies like VWAP and TWAP can help you trade smarter. 

What Is an Order Book? 

An order book is a live digital list of all the current buy and sell orders placed by traders. It shows the prices at which people want to buy (bids) or sell (asks) a stock. In India, most trading platforms display the top 5 bid and ask prices near the latest traded price—this is called Level 2 market data. Some advanced platforms show up to 20 price levels, giving a clearer view of market activity. 

To build smart trading algorithms, it’s important to understand how buy and sell orders work together inside the order book. 

How Active and Passive Orders Work Together in the Order Book? 

Active Orders: Market Movers 

An active order, often a market order, is used when a trader wants to execute a buy or sell transaction instantly, without waiting for a specific price. This type of order does not wait in the order book—it seeks out the best available price and gets executed right away. For example, if you place a market order to buy 100 shares, it will match with the existing sell limit orders at the best available prices. 

Passive Orders: Liquidity Providers 

On the other hand, a passive order (like a limit order) is placed with a specific price in mind. Instead of being executed immediately, it sits in the order book and waits for a buyer or seller to match it. Passive orders help build the order book and provide liquidity to the market. 

The Order Book: Where It All Comes Together 

The order book is a live record of all current buy and sell limit orders on the exchange. It’s essentially a table with the top bid prices (buyers) and ask prices (sellers) and the corresponding volumes. Here’s how interaction happens: 

• When an active market order is submitted, it consumes passive limit orders from the order book. 

• Consider a scenario where the lowest selling price (best ask) is ₹100. If you place an immediate buy order (market order), it will be fulfilled by that ₹100 offer, resulting in a completed trade. Consequently, that sell limit order is taken off the order book, and the next cheapest selling price then becomes the best available. 

Why This Matters for Smart Order Routing and Algo Trading? 

Smart order routing (SOR) is a technique used by trading algorithms to find the best possible execution across multiple venues, exchanges, or liquidity pools. To do this efficiently, the algorithm must understand: 

• Where liquidity lies (passive orders)

• How quickly orders are being executed (active order flow)

• How to split large orders without impacting price significantly

By knowing how active and passive orders function within the order book, an algorithm can: 

• Time its orders to reduce market impact

• Place limit orders strategically to provide liquidity

• Use VWAP or TWAP strategies to match price or time-based benchmarks

In short, mastering this interaction is like learning how traffic flows at an intersection—you can’t navigate it well unless you understand who’s moving, who’s waiting, and how the system responds. 

Different Order Types in Algo Trading 

Order Type 

What It Does 

Key Feature 

Pros 

Cons 

Market Order 

Executes immediately at the best available price 

Consumes liquidity (Market Taker) 

Quick execution 

No price guarantee, high slippage risk 

Limit Order 

Sets a specific price to buy/sell 

Supplies liquidity (Market Maker) 

No slippage, price control 

Execution not guaranteed if price isn’t reached 

Stoploss Market 

Triggers a market order at trigger price 

Trigger + Market execution 

Guarantees execution after trigger 

Risk of slippage, especially in low liquidity 

Stoploss Limit 

Triggers a limit order at trigger price 

Trigger + Limit price range 

Price control + risk management 

No execution if price skips or jumps 

Understanding VWAP and TWAP in Algo Trading 

If you’re new to algorithmic trading, you’ve probably come across terms like VWAP and TWAP. These are popular execution strategies used to break large trades into smaller chunks and execute them smartly. But what do they really mean? Let’s break it down in simple terms. 

What Is VWAP Trading? 

VWAP stands for Volume-Weighted Average Price. It’s a method that helps traders buy or sell large orders without causing too much impact on the market price. Imagine trying to buy 15 million shares of a stock all at once—that would push the price up quickly. Instead, VWAP helps divide that order into smaller parts and spreads it out during the day based on how much volume is being traded. 

Working of VWAP Trading Strategy 

The VWAP trading strategy uses historical volume patterns and real-time intraday volume data to predict when more trades happen during the day. The algorithm then places small trades during those times to match the average market activity, trying to stay close to the day’s VWAP line (a moving average-like indicator on a chart). 

• Formula: VWAP = (Sum of price × volume) / total volume traded

• Use case: Best used during normal market conditions and predictable volume days

• Avoid using: In highly volatile or illiquid markets 

VWAP also helps measure whether the current price is fair—if the price is above the VWAP, it’s considered expensive; if it’s below, it may be undervalued. 

What Is TWAP in Trading? 

TWAP stands for Time-Weighted Average Price. Unlike VWAP, which follows volume, TWAP spreads trades evenly over a specific time period. TWAP breaks your order into equal parts and spreads them out evenly over time. It’s useful when you want to execute trades gradually without drawing attention or affecting the market price too much. 

How TWAP Strategy Works?  

The TWAP strategy is ideal when you want to avoid influencing the market and don’t care about matching the trading volume. It’s also helpful in low-volume markets or for stocks that don’t follow a predictable trading pattern. 

• Even execution: Trades are spread out evenly by time

• Smart order routing: Sends small orders randomly to reduce market impact

• When to avoid: If you want trades to match market activity 

Key Takeaway 

Understanding different order types, how they function within the order book, and when to use execution strategies like VWAP and TWAP is essential for building successful algorithmic trading systems. 

• Use VWAP when you want to follow volume trends and minimise price impact

• Use TWAP when consistent pacing matters more than volume trends 

Conclusion 

To succeed in algorithmic trading, understanding how different order types interact within the order book is crucial. Active and passive orders shape market dynamics, and smart order routing relies heavily on this interplay to minimise market impact. Execution strategies like VWAP and TWAP help break down large trades for optimal performance, depending on market conditions and trading objectives.