Variance request

1. Variance Request

A *variance request* is a crucial component of risk management and strategy adaptation within financial markets, particularly relevant for traders employing quantitative strategies or operating under specific account parameters. This article will provide a comprehensive overview of variance requests, covering their definition, rationale, types, implementation, common challenges, and best practices. It is aimed at beginners, though experienced traders may find a useful refresher. We will focus on the context of algorithmic trading and automated systems, but the underlying principles apply more broadly.

What is a Variance Request?

In essence, a variance request is a formal deviation from a pre-defined trading rule or parameter set within a strategy. Strategies are built on assumptions about market behavior and risk tolerance. However, markets are dynamic and unpredictable. Unexpected events – often referred to as Black Swan events – can disrupt these assumptions, rendering a previously profitable strategy ineffective or even detrimental. A variance request allows a trader or risk manager to temporarily or permanently modify a strategy’s rules to adapt to changing market conditions, or to address unforeseen circumstances.

Think of a strategy as a carefully constructed machine. It operates optimally within a specific range of inputs. A variance request is like making an adjustment to that machine – tightening a bolt, recalibrating a sensor – to ensure it continues to function correctly when faced with unusual or unexpected circumstances. Without this ability to adapt, strategies can quickly become obsolete or lead to substantial losses.

The core principle behind allowing variance requests is acknowledging the inherent limitations of any static trading model. No strategy can perfectly predict or account for all possible market scenarios. A robust risk management framework must include a mechanism for proactively responding to these scenarios.

Why are Variance Requests Necessary?

The need for variance requests stems from several key factors:

• **Market Regime Shifts:** Markets alternate between different regimes – trending, ranging, volatile, quiet. A strategy optimized for a trending market may perform poorly in a ranging market. A variance request might involve reducing position size, adjusting entry/exit criteria, or temporarily pausing the strategy. Understanding Market Structure is paramount here.
• **Unforeseen Economic Events:** Unexpected announcements like interest rate changes, geopolitical crises, or natural disasters can trigger significant market movements. These events can invalidate the assumptions underlying a strategy. For example, a strategy based on Correlation Trading might fail if a previously correlated pair suddenly diverges due to an unexpected event.
• **Black Swan Events:** These are rare, unpredictable events with extreme consequences. They are, by definition, difficult to model or anticipate. Variance requests are often critical for mitigating losses during such events.
• **Data Errors & System Glitches:** Problems with data feeds or the trading infrastructure can lead to incorrect signals or execution errors. A variance request can be used to temporarily halt the strategy while the issue is investigated and resolved. Effective Data Validation is crucial to minimizing these problems.
• **Model Drift:** Over time, the statistical properties of the market can change, causing a strategy’s performance to degrade. This phenomenon, known as model drift, requires periodic recalibration or adjustments to the strategy’s parameters. Backtesting and Walk-Forward Analysis are key to identifying model drift.
• **Liquidity Issues:** During periods of low liquidity, it can be difficult to execute trades at desired prices. A variance request might involve reducing trade frequency or adjusting order types. Understanding Order Book Dynamics is vital in such situations.
• **Regulatory Changes:** New regulations can impact trading strategies and require adjustments to ensure compliance.

Without the ability to request variances, a strategy, however well-designed, can become a liability instead of an asset.

Types of Variance Requests

Variance requests can be categorized based on their scope, duration, and the type of modification they entail. Here's a breakdown of common types:

• **Temporary Variance:** This is a short-term adjustment, typically lasting from a few minutes to a few days. It's often used to respond to unexpected events or transient market conditions. Example: Reducing position size during a period of high volatility.
• **Permanent Variance:** This involves a lasting change to the strategy’s rules. It's typically implemented after a thorough analysis of the market and the strategy’s performance. Example: Adjusting the parameters of a Moving Average Crossover strategy to reflect a change in market trend.
• **Parameter Adjustment:** This involves modifying specific numerical parameters within the strategy. Example: Increasing the stop-loss level to account for increased volatility.
• **Rule Modification:** This involves changing the logical rules that govern the strategy’s behavior. Example: Adding a new filter to prevent trades during specific news events.
• **Pause/Resume:** This involves temporarily halting the strategy and then resuming it at a later time. Example: Pausing the strategy during a major economic announcement.
• **Emergency Stop:** A critical, immediate halt to all trading activity, usually triggered by a severe risk event. This is often automated and requires minimal human intervention. Related to Risk-Reward Ratio.
• **Position Size Adjustment:** Modifying the maximum allowed position size based on current market conditions or account equity. This ties into Position Sizing techniques.
• **Instrument Restriction:** Temporarily or permanently removing certain trading instruments from the strategy’s purview. Example: Excluding a volatile stock during earnings season.

The level of authorization required for each type of variance request should be clearly defined in a risk management policy.

Implementing a Variance Request Process

A well-defined variance request process is essential for ensuring that deviations from a strategy are made responsibly and with appropriate oversight. Here's a typical workflow:

1. **Identification of Need:** A trader or risk manager identifies a situation that warrants a variance request. This could be based on real-time market monitoring, backtesting results, or system alerts. 2. **Request Submission:** The request is submitted through a formal channel, typically a dedicated system or form. The request should include:

   * **Strategy Name:** The strategy to which the variance applies.
   * **Requestor:** The individual submitting the request.
   * **Date of Request:** The date the request was submitted.
   * **Justification:** A clear and concise explanation of why the variance is needed, supported by data and analysis.  Demonstrating understanding of Candlestick Patterns can be helpful here.
   * **Proposed Modification:** A detailed description of the proposed change to the strategy’s rules or parameters.
   * **Duration:** The proposed duration of the variance (temporary or permanent).
   * **Risk Assessment:** An assessment of the potential risks and benefits of the variance.  Consider Value at Risk (VaR).

3. **Review and Approval:** The request is reviewed by a designated authority, typically a senior trader or risk manager. The reviewer will assess the justification, risk assessment, and potential impact of the variance. Approval levels should be tiered based on the severity of the proposed change. 4. **Implementation:** Once approved, the variance is implemented in the trading system. This may involve manually adjusting parameters, modifying code, or activating a pre-defined contingency plan. 5. **Monitoring and Review:** The impact of the variance is closely monitored to ensure that it is achieving the desired results and not creating unintended consequences. Regular reviews should be conducted to assess the effectiveness of the variance and determine whether it should be extended, modified, or revoked. Utilizing Technical Indicators is crucial during this phase. 6. **Documentation:** All variance requests, approvals, and outcomes should be meticulously documented for audit and analysis purposes.

Common Challenges & Mitigation Strategies

Implementing a robust variance request process is not without its challenges:

• **Subjectivity:** Determining whether a variance is necessary can be subjective. Mitigation: Establish clear, objective criteria for triggering a variance request.
• **Latency:** The review and approval process can introduce latency, potentially delaying a critical response to changing market conditions. Mitigation: Streamline the approval process and empower traders with appropriate levels of authority. Automated approvals for pre-defined scenarios can also help.
• **Human Error:** Manual adjustments to strategy parameters can introduce errors. Mitigation: Automate the implementation of variances whenever possible. Implement robust validation checks to prevent errors.
• **Risk of Abuse:** Traders may attempt to use variance requests to circumvent risk management controls. Mitigation: Implement strong oversight and audit trails. Establish clear consequences for misuse.
• **Over-Optimization:** Frequent adjustments to strategy parameters can lead to over-optimization, resulting in poor out-of-sample performance. Mitigation: Emphasize the importance of rigorous backtesting and walk-forward analysis. Avoid making changes based on short-term market noise. Consider the concept of Sharpe Ratio.
• **Lack of Documentation:** Inadequate documentation can make it difficult to understand the rationale behind past variances and to learn from mistakes. Mitigation: Mandate comprehensive documentation of all variance requests and outcomes.
• **Communication Breakdown:** Failure to communicate variance requests effectively can lead to confusion and misaligned trading activity. Mitigation: Establish clear communication channels and protocols.
• **Ignoring Fibonacci Retracements and other key levels:** Failing to consider established support and resistance levels when making adjustments.

Best Practices for Variance Requests

• **Establish a Clear Policy:** Develop a comprehensive variance request policy that outlines the process, criteria, approval levels, and documentation requirements.
• **Define Objective Triggers:** Identify specific, measurable events or conditions that will automatically trigger a variance request.
• **Automate Where Possible:** Automate the implementation of variances whenever feasible to reduce latency and human error.
• **Prioritize Risk Management:** Always prioritize risk management when evaluating variance requests.
• **Document Everything:** Maintain meticulous records of all variance requests, approvals, and outcomes.
• **Regularly Review and Update:** Periodically review and update the variance request process to ensure that it remains effective and relevant.
• **Training:** Provide comprehensive training to all traders and risk managers on the variance request process.
• **Utilize Elliott Wave Theory for longer-term adjustments.**
• **Monitor Bollinger Bands for volatility-based adjustments.**
• **Always consider Ichimoku Cloud for trend identification and adjustments.**
• **Be aware of Divergence signals when evaluating strategy performance.**
• **Understand the impact of Volume on price action.**

By implementing a well-defined variance request process and adhering to best practices, traders can effectively adapt their strategies to changing market conditions, mitigate risks, and improve their overall performance. Ignoring the need for variance requests is a recipe for disaster in the dynamic world of financial markets. Remember to constantly analyze Support and Resistance Levels and consider Average True Range (ATR) for volatility assessments.

Algorithmic Trading Risk Management Quantitative Analysis Backtesting Market Volatility Trading Strategy Position Sizing Technical Analysis Black Swan events Data Validation

Start Trading Now

Sign up at IQ Option (Minimum deposit $10) Open an account at Pocket Option (Minimum deposit $5)

Join Our Community

Subscribe to our Telegram channel @strategybin to receive: ✓ Daily trading signals ✓ Exclusive strategy analysis ✓ Market trend alerts ✓ Educational materials for beginners