Confidence in your worst-case scenario - Dave Floyd and John Netto

About this episode:

Confidence in your worst-case scenario

Two renowned traders come together in this unique episode of the Artful Trader – Dave Floyd (founder of Aspen Trading) and John Netto (founder of Netto numbers).
Although the two have a wildly different approach to trading, there are some surprising similarities; both Dave and John attribute their success to preparation, sticking to a trading strategy and trading within their defined level of risk.
Join us as we chat through Dave and Johns’ experiences and apply their learnings to your own trading strategy. 

Dave Floyd

CMC Markets

Founder of acclaimed FX firm, Aspen Trading Group providing expert FX research and analytics to both institutional and retail clients worldwide. Dave has over two decades of expertise in technical analysis and global fundamentals.

John Netto

CMC Markets

Acclaimed author and the founder of the ground breaking Netto Numbers.  Netto is an expert in developing, executing, and managing proprietary algorithmic and discretionary trading strategies across a range of time horizons, asset classes, and market regime.

Episode 2: Confidence in your worst-case scenario

John: It's a confidence that doesn't lead to recklessness because confidence that leads to recklessness can be a major risk management issue.

Dave: I think it's been positioned in the market as if you just do these three simple things, that's all you're going to need to be successful, but that's on top of many, many other things that are required that aren't so simple.

Michael: From CMC markets this is The Artful Trader.

Michael: Hello and welcome to The Artful Trader. I'm Michael McCarthy, chief market strategist at CMC Markets, Asia Pacific. In our third season, we talk to the experts in their own fields to uncover what gives them the confidence to succeed. We uncover confidence, unlocking the secrets behind resilience, preparation and growth and how it can make you a better trader. One of the best and maybe the worst things about talking to traders is that once you get them started, sometimes you just can't get them to stop. Well today we have an Artful Trader first. We'll be talking to two guests, Dave Floyd and returning star John Netto. Both are great traders and as it turns out great friends. Dave Floyd has over two decades of experience in the markets and founded the Aspen Trading Group. John Netto is the founder of the Netto Number. He authored The Global Macro Edge, which he discussed with some of our clients in a session here in Sydney as a follow-up to The Artful Trader season two. We kick off this episode with each of them separately and then bring Dave and John back into a group discussion to chat through strategy, defining risk and their own experiences of the markets. This is a really unique session and I hope you enjoy it.

Michael: It's my pleasure today to welcome back one of our few returning guests. We try to cover a lot of territory in The Artful Trader podcast and for that reason we have a wide variety of guests, but we knew John Netto had more to tell and we had more to learn. A bit of background first, how important is knowing yourself and knowing your style in trading?

John: I think it's essential and knowing yourself and knowing your style, you know, when I understand my personality, having been someone that's taken on risk for pretty much all of my sentient life, you know, as long as I can remember being someone who can think and breathe and eat the idea of risk always had appeal. Whether it was, you know, betting on American football or whether it was the market or whether it was, you know, the outcome of some personal life event, knowing what that risk was and being able to define that brought a sense of comfort. And so what I know about myself and why I define things on a return per unit of risk basis, is because I know that the way that I mitigate anxiety, the way I mitigate acting out of impulse or breaking a plan is by understanding and defining what my risk is into a trade. Then once I'm comfortable with that risk, now the anxiety can be reduced because now I've made this a numbers game, as if I, the same way I would play poker or the same way that you set up a budget. Having a risk budget per trade per portfolio per strategy is both a factor of knowing myself and also frankly a by-product of a better way to invest.

Michael: John, for those who haven't had a chance to go through The Global Macro Edge, one of the key revelations there is that standardization of risk units. This is a big step forward for the trading world and it reads as if this is very central to your trading approach?

John: It is. You know the book is called The Global Macro Edge, maximize and return per unit of risk, not maximizing returns, not maximizing profits, not, you know, trade from a yacht. It's about in advance defining what it is you're willing to risk on a position, having a strategy. And risk comes in a couple of ways. Risk comes in the size that you're risking, meaning the position bet, whether it's a percent of the portfolio, whether it's a volatility target that you're making, but whatever it is, it is an amount that you determine in advance and that you adhere to. It comes from having a plan. And I think, again, going back to the whole risk budget thing, the risk budget is a microcosm of a plan in general. What are you going to do when your portfolio hits this threshold? What are you going to do if the market reacts in this way? Now again, it's logistically maybe not feasible, that you can plan every single scenario. But having multiple scenarios planned from both a trading perspective and from just a business perspective goes a long way to easing one's uncertainty, one's doubt. And if you can mitigate that you could trade with a lot more confidence.

Michael: You stress a real difference between risky trades and risk-defined trades?

John: You know that's a great question Michael. Thank you. You know, people in general, you see a lot of disclaimers about trade and they talk about trading can be risky, or you see people speak almost too casually or almost flippantly about, oh, the market is risky. And what they fail to do when they say that is they fail to categorize what risky is. Whereas Mike, you and I and many of the CMC listeners and many people from CMC markets listening to this are in the business of making risk defined trades. Risk-defined trades at a very granular level, you know, have through research, through diligence, through a plan, through experience, through understanding the novel aspects of the market, through understanding the idiosyncrasies of a market. Look to exploit edges that exist from these anomalies in the market, and they look to exploit those edges by defining the risk in a trade. For example, if there's a 35% chance that this will happen, but you can make four to one on your money, then that's a risk-defined trade that gives you a chance of making money or a chance of achieving a positive expected return. And so the idea that, oh, you're taking on risk, but are you taking on risk for the sake of taking on risk or are you taking on risk-based more out of impulse or are you taking risk-based more out of process. And risk defined trades take on trades based out of process.

Michael: Sticking to your process is one of the key disciplines for you?

John: It is, and part of my process is being open that the process needs to evolve. There's a fine line between being stubborn and or being confident in your system and then just flat out not adapting. And it's funny because ex-post, you know after the fact, anyone can tell you that if you're in a position and if it, you know, when it's profitable, then it goes against you, you know, you'll hear the saying, oh you can never go broke taking a profit. On the other hand, if you're in a position and you take profits and it keeps running, then you'll hear the people say, oh, you got to let your winners run. And everyone can say this after the fact. Everyone can come up with these, oh keep your losses small, or don't ever trade with stops or don't you know, all these things after the fact. What I try and do is look at what I'm doing and start with a big question first. How do I make money in this? All right. Because as we talked about last year in the second season Michael, analysing the market and making money from that is a completely different skillset.

Michael: John, you've said in the past that you're genetically predisposed to taking risks. Is that true? Were you born to trade?

John: Well I can't speak extensively to my DNA sequencing, but I do feel anecdotally that given my behaviour of placing my first sports bet at the age of eight, the fact that like I read my first book on derivatives at 12 and ran a bookie operation at high school. As I say, provided liquidity for those wishing to prognosticate on the outcome of sporting events, given that set of anecdotal behaviour and I guess in this case empirical, when you look at some of my sports betting performance. It's very likely that I was predisposed or am predisposed to take on risk, and given that I guess you can say I found my calling.

Michael: Indeed. You've always had a lot of confidence in your trading, John. Does it come and go?

John: Yeah, I don't know if I've always had a lot of confidence in my trading. Confidence waivers invariably with some of the highs and lows. I mean, I've had a lot of existential questions about my trade and I think like everyone else, and I can convey one thing to everyone here is that no matter how great a trader is, that at some point in time or more likely than not many points in time they've had questions about the efficacy of their strategy. And more existentially to what degree they would be around in this business. And this is not something that I can say that I have so gracefully escaped in the last 20 years, and multiple times, even during major win streaks, you know, we're all emotional creatures. Okay, we all have self-doubt. Doubt is healthy actually. I think doubt can be the fuel for greater creativity, for greater innovation. I think what you want to be aware of is that self-doubt is natural and normal. It's overconfidence that's probably more problematic. So you know, I definitely have confidence, but the balance between that is like a quiet confidence. It's a confidence that doesn't lead to recklessness because confidence that leads to recklessness can be a major risk management issue.

Michael: That was John Netto. And now it's my pleasure to introduce Dave Floyd. Dave, thanks very much for joining us for The Artful Trader podcast. In trading circles you're very well-known and past Artful Trader guests, including John Netto and Raoul Pal are very familiar with your work. Given your fame, especially with the Aspen Trading Group, let's cut to the chase. What does it take to become a successful trader?

Dave: Woo, well I.

Michael: Easy questions first.

Dave: I think there's an element that you have to have to be successful that you're probably either born with or just simply not born with. And that is the kind of the emotional or what they would call the emotional IQ or the EQ, and that really boils down to discipline and patience. I think that might be able to be learned over time. But I think some people just either have that or don't have that. I think people can learn the basic rules of trading, but in order to be confident and to be successful in the long run, it does take the combination of the process part, which can be learned for the most part. And then integrating that in with your experience, feel, patience and discipline. And you know, for me, I know that's why I'm still in the industry. I'm very, very patient. I can go a long period of time without making a trade, because at the end of the day our job as traders isn't necessarily to, you know, use the market like an ATM machine. It would be nice to do that, but markets don't work like that. And a lot of people approach them as if, well, if the markets are open, there must be something to do. And that might be true for the trader down the street or the trader down at, you know, at a different bank because their style is conducive to what's happening in the market. But you know, for me, I could go a week, two weeks without making a trade and that's okay. A lot of people get really uncomfortable with that. I would say that the old adage of traders make 80% of their money 20% of the time is probably a pretty fair, pretty fair assessment. And if you can get your head around that and be patient and be disciplined, you can be successful as a trader for sure. But you've got to get over that initial hump and you've got to go through a long period of time where you kind of perfect your craft.

Michael: And there are a lot of misconceptions that particularly new traders bring to the market Dave. You've just highlighted a key one there. Trading is not a salary generating business. What are some of the other misconceptions you think are popularly held?

Dave: Well, I think, you know, it probably cuts across every industry because we're human beings at the end of the day, and human beings want the path of least resistance. It's a natural thing. I mean, you look at the diet industry, you know, three simple steps to lose 50 pounds. Well, yeah, but you've also got to do this and you've got to stick to the plan, and again everybody wants the quick fix. Trading has been sold that for as long as I've been in the industry. I think it's been positioned in the market as if you just do these three simple things, that's all you're going to need to be successful. There's an element of truth. There are probably three simple things you do need to do as a trader, but that's on top of many, many other things that are required that aren't so simple.

Michael: What building blocks can new traders put in place? What do you think they should be focusing on?

Dave: If you can, if you've got the wherewithal to kind of define how you want to trade, meaning that, do I want to be an intraday trader? Do I want to be a swing trade, do I want to be an investor? If you can identify that, then you can start to look and say, you know, who could I emulate to kind of get me off the ground? Well this person over here seems to trade in a manner that seems consistent with my risk tolerance, my timeframe. Maybe I'll learn a few tricks of the trade and follow along. I mean, nothing beats emulating someone else early on, but then you eventually kind of develop your own trading style that's conducive to who you are. But you do have to get off the ground. And when I started day trading, I had some ideas of what would make money, but my confidence wasn't there, because I didn't have enough swings at the bat, so to speak, to know that if I press the button on the computer and got filled, if that would work out. You know, it's the classic fear. A lot of people don't make successful trades because they're fearful, they don't know enough or they think they don't know enough.

Michael: So how does a newer trader or even an experienced trader bounce back from a big loss?

Dave: Oh, that's a great question. And we all go through losing periods. For me, I don't have big losing periods. And what I mean by that is I'm never position sized so that if everything goes to a correlation of one or if I have four or five losing trades in a row, which is, it does happen. You know, maybe statistically it's a little less likely than having two or three losing trades in a row, but if that does happen, my drawdown from a mathematical perspective is I can recover from it. Not only financially but also mentally. I mean, we've all seen the drawdown tables and you know, once you start getting to 15, 20% drawdown, not only mathematically is it very hard to come back, but think about where your mental state is at that point in time. You know, you're beaten up and bruised. So even if you are willing to get back on the horse, trust me, you're going to be gun shy. You're probably not going to size up your next trade properly. It's going to be lighter. And of course that'll be the trade that really works well and you won't be positioned properly to regain your capital. So I think it's more of a, I think my answer to your question is more of a function of how do you size your trade so that you don't dig yourself a big hole in the event of one of those losing streaks. Because if you can prevent that, you can get back to square one and then beyond because we're all going to hit those losing streaks. We're all going to have four or five losing trades in a row. It's inevitable. It's a question of can you get recovered from it? And for me personally, I never risk more than 1% of my total capital. Well maybe one, one and a half percent if I'm really convinced on the trade. And that keeps me from, if I'm down, you know, five or six trades in a row, I'm down five, 7%, maybe 10% if I had a couple of beefier positions, I can get back from that, mentally and mathematically.

Michael: So your trading plan takes into account that you need to protect your confidence in the market?

Dave: Absolutely. I mean, I vary my bet size on every trade and I know John will probably talk about this in his portion and we'll probably talk about it when we come back and talk all at once. But every trade I put on the bet size is always commensurate with where my stop-loss is. And if you know where your stop loss is, you know exactly how many lots you should be trading so that if you do get stepped out or stopped out, you're not surpassing that risk level on a per-trade basis.

Michael: All right, well that sounds like a good place to bring John back into the conversation, if that's all right with Dave?

Dave: Sure.

John: Mike, let me tell you one thing okay. It's always a good place to bring John Netto back into the conversation all right.

Michael: Excellent. Well, I'd like to go back to something you said earlier John. You talked about the development of your trading style and drew a parallel with your development as a human being. Now I was a market maker in options on the old ASX trading floor a couple of decades ago, and in one of those quiet periods it hit every trading floor, one of the other traders turned to me and said, I love trading because it teaches you so much about yourself. Dave, what's trading taught you about yourself?

Dave: Oh God, lots of things. It exposes every, you know, weakness and strength that you have. It's part of the reason I've been in this industry for so long is it's taught me to be respectful, that you can't possibly account for everything that could go wrong. Some things will happen. You will have bad trades and you'll have a series of bad trades. But I think on the positive side is that if you really focus in on where you're good and are willing to stick with that even during the quiet periods and not jump around and get bored, that's when you start to really increase your confidence.

John: What I've learned is that not every hour watching the market is the same and I'll watch the market where I'm actively thinking, actively engaging can be exponentially more beneficial than an hour where I'm like reading email, I'm surfing the net, I'm sending IMs to people. I'm still pissed about the Dodgers losing last night, you know what I mean or whatever. Like so that, that time is really critical to developing your trading style you know. I know people who have been trading for 20 years and I'm not sure they're much better in the last 10 years just giving kind of some of the things they say, you know. Part of working on your craft is what are you doing today to get better? What are you doing today to improve your process or at least in this next quarter, in this next six months, what's part of your plan for professional development? And so what I've learned is that when I don't do that, when I'm not looking to actively improve, when I'm not looking to develop, I can stagnate. And stagnation leads to complacency and it leads to not asking the right questions and missing opportunities. It's like, man, if I would've just done this, and again we all say that, but I try and say it in a self-reflective way to get better. Okay, what could I have done today? You know, what, why didn't I do that? Well, for the third time now I've said that I should be, you know, doing a better job of memorialising the time and frequency of Trump tweets compared to its influence on the US dollar. You know what I mean? And I should have a better database of this stuff. That's one example right there you know, and yes, I've kept a database of Trump tweets and I've put a qualitative analysis behind it, but there is still further things which I'm going to keep for myself that I can be doing to make that better. And so that's an example of identifying what regime we're in and are you making idiosyncratic adjustments, nuanced adjustments that acknowledge that to make yourself or give yourself a better chance of success.

Dave: One of the thoughts I was having as John's talking about that we are so inundated with information as traders, we have anything we want kind of at our fingertips nowadays. So it's very easy to, you know, try to take in a lot like its like drinking from a fire hose. The fact of the matter is our brains have not evolved to be engaging and multitasking the way that our society says we should be now. The data's pretty clear that if you're multitasking, you're not doing, you're not being as effective at whatever it is you're doing. Whether it be trading, it could be writing a book, whatever the craft is. You might be sitting there doing some deep analysis on a chart. You're really integrating in some quantitative analysis and whatever else, and your email buzzer goes off and you immediately stop and go look at the email. And you're like, well, I only took 30 seconds I'll just go right back to where I was. You've lost so much of that mental energy, and I can't really describe it the way they did in the study, other than to say that if you do that, you're really, really doing yourself a disservice. So maintain that focus and don't multitask. That's the takeaway. Again, the research is about as clear as it gets. It's not even open for debate. Don't multitask, you'll be a far more effective trader.

Michael: Well, it's not a surprise in speaking with highly successful traders that focus, discipline, process are words that keep coming up, but perhaps a little more surprising though, is that both of you incorporate intuition into your trading style. Now that's something that, well, metaphorically at least was beaten out of me as a young trader. Trading on your gut was considered an error, and you're certainly not talking about that style of trading where you just think it's going up let's buy some. Clearly you're doing it within a process and within a disciplined framework, but what tipped you off that your feelings and intuitions were important to your trading success?

Dave: Too many instances of ignoring it and then seeing what the outcome was. Either ignoring, getting out of a trade that I was in, but I still liked it, but my gut was like, you know what, I'm just not feeling comfortable here, or getting that gut feeling and not executing the trade to get into the trade. And then, you know, a few days later you're like, damn, that was the ideal entry. So for me, it was really only, I only have to touch the hot stove burner so many times before I figure out that I shouldn't do that anymore. Or in this case I should be doing it, sounds really weird, but it's almost like an internal feeling. You're just like, aha, time to execute the trade. I mean, I'm already thinking about it anyways. It's not like out of the blue I'm like, I'm going to get long dollar Yen. Well dollar Yen wasn't even on my radar. It's about something that I'm already hammering away at and looking for that entry point and then suddenly you're like, let's go for it. And inevitably they work out really well. It's almost like you nail it to the tick.

John: You know, I have to echo a lot of what Dave says there.

Dave: That's okay to echo what I have to say, I got a lot of good insights.

John: You have tremendous insight you know. Almost as good as mine even, it's great. I'm going to draw an American sports metaphor to kind of bring this one home and you look at some of the greatest US Quarterbacks or if we want to go more on the international scale, some of the great, you know, forwards or look at Lionel Messi and Lionel Messi for Barcelona is a facilitator. He's allowed to use his intuition on the field. But now, Barcelona plays a very specific style. They like passing the ball. They have a lot of possession. They have 65 to 75% possession, and Messi is a, you know facilitator on the right-wing, and he uses his left foot to come back across the field and set up and facilitate the ball for other players. Great US Quarterbacks have an intricate offence, but they do what's called audible when they get to the line of scrimmage. They see the defence, they see what's happening, and they use their years of experience. On top of a foundational approach of play calls to then determine when appropriate. It's not every time that you come to the line of scrimmage in American football, and you audible, or in essence you change the play, all right. But what Dave is talking about is an objective appreciation of specific market circumstances that are a combination of how he uses his craft, how I use my craft as well as an understanding that this is something unique here that's not readily quantifiable. And so intuition is, yes, the external manifestation of our internal analysis based on both fundamental rigor and qualitative interpretation.

Dave: That's the best way to describe it. Seriously.

John: You're welcome.

Dave: No, that was really good. It was really good. And I like the Quarterback analogy. That's absolutely true. They're looking at it and going, okay, I've seen this before. I've got to make that adjustment.

John: Exactly. That's the Mike linebacker. They're coming to blitz on the left side. Running back, pick him up, 27 Bravo, boom. I have a hot rod, who's my hot receiver on this blitz, there you go. And like these Quarterbacks from their years of experience, and not only experience, but like finessing their craft, the preparation. I think what Dave and I really are stressing here is just how much we prepare. Okay. Knowing our strengths, you know. I know that my strength is, I'm very good at taking on outsize risk when the situation calls. Not everyone can do that. Okay. Dave has tremendous patience. He's extremely procedural. He's very process driven. Okay. But at the same time, a lot of intuition, so we know our strengths and we build systems around, we build our style around, we build our risk management methodology around these specific factors. And it's why we've experienced the success that we have.

Dave: I always try to think of my day-to-day trading as simply another chapter in the book. You know, the markets don't change very much on a day-to-day, week-to-week basis. I mean they make changes over time, but again, if you're sticking with the, for me at least, if you stick with the narrow list of securities that you're trading, you know, for me it's five or six FX pairs, the S&Ps, 10 year notes and then you know, occasionally another broad-based ETF. Every day is just kind of like a new chapter in the book or even a new page in the chapter. Not much has changed, but you wake up and you're like, okay, that's kind of where we were yesterday. I thought this might happen. So you're building that narrative and then when you get enough information, just like when you get towards the end of the book, you start to maybe figure out who, 'the who done it' in terms of the murder mystery and you've got real conviction because you've kind of been feeding yourself bits of information along the way. You know, develop that narrative day in and day out. Some days it's going to be really, really boring. But again, on that day where it's not boring, your conviction level is going to be much higher, the intuition is going to come through more, and I just think that's the more realistic way to approach the market. You know, a lot of the guys and a few gals that I know that are at the top of their game at really big hedge funds, they're not running scans every night to find out what to trade the next day. Their mandate is real simple. You trade Euro and dollar Yen, that's all you trade. So you know, if the big hedge funds are telling their individual traders and their analysts to keep a narrow focus, probably not a bad idea to follow the Paul Tudor Jones and the Citadel and that kind of business model, at least in terms of the ethos that they're promoting. That's how you get to be sitting where I am 20 plus years into the game and still saying I've made it, I've done well and I'm still continuing to learn because it's an unfolding process that takes time and you're never going to perfect it, but you do get better.

Michael: I think that's a perfect note for us to finish on. Thank you Dave. Thank you John.

Dave: Thank you very much.

Michael: That was Dave Floyd and John Netto. If you liked what you heard on episode, next time we're talking to Aussie tennis legend Pat Rafter. He opens up about the highs and lows of his career and keeping overconfidence in check.

Pat: Complacency most times sort of will bring you unstuck.

Michael: Make sure you subscribe to The Artful Trader podcast to hear Pat Rafter and all of our interviews, or listen at Join us next time.