DEFINITION of 'Split Block Pricing'

Split block pricing is the act of dividing up a large order of financial securities (also known as a block) into several smaller lots so that a large trade can find more liquidity, such that each portion may be traded at different prices. The ultimate effect of using a split block pricing method is that the trader will receive the order at a price equaling the weighted average price of each piece of the block that is traded. In some cases, split block pricing would be used on a large trade order in order to match smaller positions desired by counter-parties to the transaction.

One common type of a split block pricing strategy is the volume weighted average price, or VWAP. The volume weighted average price is a strategy  used primarily by institutional investors such as mutual funds to make large purchases and sales in a security so as not to influence the market prices with the order. It is the calculated as the average share price of a stock weighted against its trading volume within a particular time frame, generally one day, and is frequently employed with the aid of execution algorithms or an inter-dealer broker. Split block pricing is employed in several types of markets including stocks, options, and bond markets.

BREAKING DOWN 'Split Block Pricing'

Example of Split Block Pricing

For instance, a trader at a large mutual fund's trading desk wants to purchase 50,000 shares of ABC Inc., but she knows that entering this order as a market order will move the market quite a bit higher unnecessarily, and posting a limit order to buy will expose her hand. Instead, she seeks split block pricing using the volume weighted average price method. There are several steps involved in the VWAP order. First, she must calculate the usual price and volume (the number of shares traded over some period) for a typical trading day in ABC shares. This is usually estimated using the average of the daily high, low, and closing price, multiplied the period's average volume. Next, she will keep a running total of these values and volumes, known as a cumulative total. Finally, she will need to divide the running total of average price by the running total of average volume. The formula given for these steps is summarized as:

Another example comes from the options markets. Say a trader wants to sell 1,000 call options of XYZ corp, assuming that the only two buyers of the XYZ options want to buy 600 options at $5.00 and 400 more options at $4.95; the order will be split into two blocks of 600 and 400 contracts, respectively and the selling trader would receive proceeds of $501,000 ((400 x $4.95 x 100) + (600 x $5.00 x 100)), or an average price on the split block of $5.01.

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