Bitcoin prices are fun, if you like roller coasters. For traders who see volatility as an opportunity to make money and are willing to accept the risks, this is great. However this volatility presents a risk for long-term investors, fund managers and businesses who use digital currency for day-to-day operations. The newly launched algorithm for Bitcoin trading, TWAP (Time Weighted Average Price), could save both money and headaches for people and companies not equipped for higher risk.

Benchmarking Your Trades

On January 15, 2016 at 21:58 GMT (Figure 1), the price for bitcoin was $390. In an hour, it dropped to $365. I'm sure you have your own annoying price drop stories. This kind of volatility creates multiple challenges. First, it increases risk; and second, it makes it difficult for your stakeholders to know whether you are providing them a fair price.

Companies using Bitcoin for operations rely on the price of bitcoin. If in one hour — about the time it takes for six confirmations — the price of BTC can swing by 7 percent (and it does!), companies need to add a buffer to account for it. Thus, volatility increases the overall cost of using digital currency.

Stakeholders care about your Bitcoin trading strategies. This includes the CFOs of firms (e.g. Bitcoin mining firms), your limited partners, suppliers, merchants and customers who are relying on you to get them the best price. Using digital currency is risky enough for customers, and asking them to take on additional trading risk is cumbersome. They don't ask you to predict the market but they do ask that you give them a fair rate.

One way to evaluate and communicate your performance is to use a benchmark. A good benchmark averages out the volatility and provides you with a price that your stakeholders can trust. Digital currency fund managers, for example, use benchmarks to evaluate their trading strategies and make sure they are not undertaking additional risk. Payment companies who have inflows of digital currency throughout the day often use a benchmark rate to communicate to their customers.

How TWAP Works

To gauge trading performance, many traders in different asset classes (equity, fixed income, currency) often use average price as a benchmark. The two common ways to calculate an average are a time-weighted average price (TWAP) and a volume-weighted average price (VWAP). TWAP is the average price of a bitcoin over the course of a specified period of time and VWAP is price multiplied by number of bitcoins traded, and then divided by the total number of bitcoins traded during a time period.