DAVID FLOYD: All right, hey, good afternoon, traders. David Floyd here with Aspen Trading Group on behalf of Real Vision Access. I'm back with another interview with a very interesting friend and colleague. You'll remember, back in January, I sat down with Peter Brandt, and we discussed the euro. Today, though, we're going to kind of switch topics a little bit. We're going to stick with the FX market. I've got Brent Donnelly of HSBC Bank. He's an FX market maker, and also the author of a book I strongly suggest you read, which is "The Art of Currency Trading."
And I'm not saying that just to do a book plug. I've been in this business for 20-plus years. Most of the trading books out there are-- let's be nice in terms of my word choices-- marginal. When I read this one, I knew that Brent was actually a practitioner of what he did because of the way it was written and the way he spoke. You could tell that his process was very methodical.
So I thought, what a better-- what better person to have on Real Vision Access to not only provide a little bit of insight as to what he does on a day-to-day basis at HSBC as a market maker, but let's get into his methodology. And also, let's maybe talk about what's happening in the markets currently, because certainly there's plenty to talk about.
So rather than me hogging all the time, Brent, welcome. It's a pleasure to have you on. Why don't you tell us a little bit about what a market maker does on a day-to-day-basis, and we'll go from there.
BRENT DONNELLY: Sure. Hey, Dave, and thanks a lot-- thanks for having me on. So the market making rule is pretty broad, and it's been dynamic over the years because of automation. So a lot of market making now in all the businesses at banks is automated.
So what that leaves us to do is execute the big tickets. And then, also, the role much more has become to be the expert in your currency. So whatever currencies you trade, you need to be the expert in those things. And then you can communicate with clients and help them strategize so that even if they are generally longer term and my perspective is shorter term, when they come into transact, their time horizon obviously shrinks to much shorter. And then we try to help them execute as best as possible to get the best or to create the least footprint on the bigger tickets.
And then, in the meantime, I'm trying to be strategic about my own book and position in anticipation of what I think the market's going to do so that I'm not offside. Let's say, if I think dollar/yen's about to explode higher, then I want to be long some dollar/yen so that when clients come in to buy dollar/yen, I'm not offside, and I'm not caught wrong-footed.
So in order to do that, you use a lot of the same tools that anyone would use who's trying to generate alpha, which is whatever systems you use and you know in terms of technicals, fundamentals, sentiment, cross-market, lead-lag, all that kind of stuff, which I'm sure we can dig into a little bit later. But so you end up using all of those techniques that somebody's sitting at home trading would use similar techniques, I would hope, to anticipate short-term movements in the market. So just one more thing. So generally, my way of looking at the world is very macro. But then the way that I actually act in terms of trading is quite micro.
DAVID FLOYD: If you want to-- if the guys back in the control there want to bring up slide number nine. I mean, you just gave me a great segue. But slide number nine has some of your rules of trading. And one of the things you say in there-- and let me pull up slide number nine here. I got it right here. Give me a second-- get it on my screen. Hopefully, everybody at home can see it.
BRENT DONNELLY: The auto-correct doesn't like my spacing.
DAVID FLOYD: There it is. It says right in here-- these are some of the-- this slide is titled Main Factors I Consider When Putting on a Trade. And one of the ones you put in there was technical analysis. And you said in parentheses, risk management and tactics. This is a line I like, and I want to talk about this-- why I am skeptical of technical analysis as a forecasting tool, but why I still use it all the time. So talk to me about that. Talk to our viewers about that.
BRENT DONNELLY: Sure So this is a big topic. And hopefully, I'm not going to be too controversial because, I mean, there's no right answers. Like I say at the start of the book, take what resonates with you, and ignore the rest. I think everyone has to develop their own style. And I read a lot of books when I was coming up trading, and a lot of it I didn't like, and some of it I liked. And then you take what you like, and you throw the rest.
But I do have a very strong view on this specific topic is that, generally, technical analysis should be used for tactics, and it should be used for risk management, and a lot less for forecasting where the market's going to go. And there's a bunch of reasons for that. Number one reason is very few to actually zero traders that I've ever worked with that were very successful only use charts.
Another reason is that that stuff is the easiest stuff to automate. So in the world of algorithmic trading, if you think you can look-- draw a trend line and then sell when that thing breaks, and that's going to be a long-term viable strategy in the world of algos, I think that's questionable. I just feel like it doesn't pass the sniff test of-- it's kind of like if-- I'm sure a lot of your viewers play poker. It's kind of like knowing the opening hands in poker. It's a necessary condition, but it's not sufficient.
And that's what I feel like with technical analysis is that it gives you some indicators, and it tells you, OK, if this breaks, I'm wrong. But as a forecasting tool, I just don't think that it's enough. And there's also quite a bit of research on this. There's an entire book that backtests every single pattern. And generally, out of sample, if you just backtest something like Head and Shoulders, it doesn't backtest profitably. And the things that do backtest profitably presumably have been automated. And as things get automated because of efficient markets, then that-- a profitable pattern eventually gets arbitraged away.
So I feel like more and more in recent-- in the recent era, the idea of just trading pure charts and pure technicals is not profitable. And generally, there's a lot of empirical data to show that. And I've seen a lot of anecdotal evidence of that as well.
Now, on the other hand, there's also evidence that shows that traders that use technical analysis outperform those that don't. So those two things kind of contradict. And you'll be like, well, why is that the case? The answer to that is pretty simple. It's that if you don't use technicals at all, if you buy something at 10 and it goes to 8, then, obviously, that looks like an even better buy because you're now-- it's 20% off. So I think, generally, if you don't have some kind of technical system to risk manager positions, then the lower something goes, the more you want to buy it. As opposed to what I think the most direct usage of technicals is to say, OK, if this breaks, I'm wrong-- whatever you want to use, if it's moving averages, or trend lines, or supports.
To me, also, again, this is a philosophical thing, so I'm not claiming to have the correct answer. But my philosophy after going into a little bit more of the esoteric stuff is that there is a lot of room for subjectivity, like an Elliott wave, and GAN, and all that stuff. And so I've never found it useful for my process. In fact, I've gone more like Occam's razor style, where you just-- the simpler the thing is, the better.
And also, I think a lot of times, you can explain-- and maybe this is easier if you sit at a bank. But a lot of times, you can explain why something very simple like support and resistance works is because there's huge orders in the market. And those people that are putting those orders in the market are patient, and they have a medium-term or long-term time horizon.
So say somebody says, I want to be short the end, and I want to buy dollars. But I'm not really that worried about it. And I want to get a good entry point. So I'm going to put a bid for $2 billion dollars at 108.50. And if we get down there, maybe even the rest of my portfolio is doing well so I don't need to panic to buy it. And then, suddenly, every time it goes to 108.50, it seems to bounce off of that level. And then people start noticing it. And then all the bids are forming above and stops below that level.
And so I think the simpler technical analysis to me generally has a easier underlying explanation in terms of flow and human behavior, whereas when you get into like Fibos and stuff like that, the self-fulfilling prophecy aspect is not there because if everyone's-- if you-- I actually have the thing in the book, but it's not in these slides.
But if you take a market that has moved a lot and then start drawing all the Fibos on there, you can basically fill the things so it looks like a Los Angeles highway interchange, where there's just lines everywhere. And part of the reason that I say that is that you experience it a lot where people go, hey, this is a 38.1 of this move. And then you go look, and you're like, oh, I'm looking at a different move. And then, all of a sudden, there's like six different 38.1s, and then the 50s and all that.
So anyways, very long answer to say that I feel like it's a tactics thing. And also, I think the idea of something simple working is very appealing and also very unrealistic. So it's easy to sell online a package of technical holy grail kind of things. But it's a lot harder to sell, like, hey, if you do a whole bunch of work and spend 10 years learning about this business, then maybe you might be able to make money, even though most people don't make money. You know what I mean?
So I think the reality is that a lot more has to go into your process than just technicals. But without technicals, I don't think you can really succeed any-- either. So again, going to the idea of necessary but not sufficient condition for success.
DAVID FLOYD: Well, I'm really glad you brought that up. And again, one of the things that resonated, not only in my conversations that we've had from going back to when I first got introduced to you back in November, but it's very clear from the introduction in your book. This whole notion of that everything can be boiled down really simply, and it makes it easy for you to make money is a bunch of BS. And unfortunately, people buy that up.
So I'm really glad you gave that explanation, because people don't want to be told, well, it's going to be a long, arduous journey. And then you might not succeed. They want to hear three simple steps.
But I try to tell people when I can. And it's kind of like talking to an empty room. People don't want to hear that. But that is the reality of the business. And focusing in on very simple things, and looking at other markets, and other things other than just charts is actually really helpful.
And I know I'm speculating here, but I suspect, like me, you can only keep an eye on a few markets and become really intimately familiar with them. And that, to me, is where you can gain an edge, because that's something that maybe the algorithms don't have. There's that whole sense of feel drawing on one's level of experience.
I know there's been studies done on more of the neurological aspect of it, but the longer you watch something, whether it be you're becoming an expert attorney or a firefighter or whatever, you get this inane sense or this experience that you can call upon. And sometimes it just happens where you're like, I know it's time to go long the euro here. But you don't logically know why that's the case, but your brain does have a way of interpreting all this vast amount of data.
My point being is that if you're constantly on the prowl for the trade setup of the day, which, of course, is a bunch of nonsense, you're going to miss out on those really, really robust nuggets. So I'm really glad you brought up that whole concept. It's not to burst people's balloons. It's to put them in a place where they go on the path where they have the most realistic chance of succeeding.
Let's talk a little bit about position sizing. You had that in one of your slides as well. It's also in slide number nine. Talk about position sizing and how important that is. I mean, I guess you could make the argument that even if you had a marginally robust trading approach or system, whatever you want to call it, if you position size yourself properly and just simply get a statistical edge in terms of your size of your winners relative your loser-- relative to your losers, you could be a successful trader.
But as we all know, when you get kicked a few times in the teeth but some losing positions, you start to trade last. And then you should-- when at the same time, you should be position sizing more consistently. Talk to me a little bit about that. How do you do that on a day-to-day basis? How do you keep your focus when maybe things aren't going so well, and yet you've got to put the right position size on?
BRENT DONNELLY: So yeah. I mean, to me, that's probably the hardest part of trading is that you can develop whatever systems you want. And I mean, the hardest part of discretionary trading is you can develop whatever process. And however robust that process is, there's generally two extremes. Either you tend to size too small because you're hesitant or you tend to size too big because this feels like a huge opportunity, and everything feels like a five star trade.
I tend to be more on that side of the continuum, where like I tend to get a little bit too excited. So you're describing like a trigger-shy person who's not doing well. And often, I have the opposite extreme, which is if I'm doing really well, then I get overconfident and I position too big. And so I think the key to that is really just trying to be as systematic as possible, and robotic as possible, and having a spreadsheet.
So that was also a big challenge for me when I worked at a hedge fund was at a bank, you have a fixed amount of PnL that you're working with, whereas at a hedge fund, often your capital changes. It might even change every month. Sometimes it was changing every month for me. So identifying like how am I going to size correctly when my capital is completely-- might double one month.
And so what that taught me is being really rigid about just using a specific percentage of the amount of capital that you have at risk. And again, I don't think there's a right answer. I think for each individual, there's a right answer. But for the market-- the world as a whole, I'm sure a lot of your viewers have read like 2% of your free capital as a guideline. I feel like that number is something that you really have to develop, but it has to be-- you have to be very disciplined about it. Because I think the hardest part is just following the rules of properly allocating your capital, and not-- for me, not getting overly excited thinking this is a huge opportunity.
There are so many opportunities. If your timeframe-- my time horizon is three hours to three days generally is how I would hold a position, even though I might hold a view for much longer. I might have the same view for a month, but I might jump in and out over the course of a couple of days and modify my-- try to buy retracements in a bull market or whatever.
But I think that sizing correctly ends up probably being-- once you know the basics of whatever your methodology is, that tends to be the key. Because if you-- especially if you-- I mean, I had times when I didn't know what I was doing when I was younger, where you're just-- you see some catalyst, and you just jump in, and you buy whatever.
Say you buy 50 million euros, but say the appropriate position size for your amount of PnL tolerance or capital was 15, not 50. Then there's a tiny retracement. And all of a sudden, you've hit your daily loss limit. And then it explodes higher, but you had to step out on the retracement because your position was the wrong size.
And it's really, really hard not to-- if you're an aggressive person with a lot of risk appetite, I think it's hard not to be overconfident, especially as you have more experience and more and more trades appeal to you. And the thing that really-- other than just getting smashed in the face by the market over and over-- that obviously teaches you the lesson.
But the other thing that has taught me over the years is collecting a lot of data on my training. So for example, I know from many years of-- I create a new spreadsheet every year, and it has my PnL. That I pretty much win 50% of days, and I lose 50% of days. I used to work at Lehman Brothers back in 2005. And I have those spreadsheets. And it's kind of insane how consistent that is.
What is determining my success in any given year is the ratio of my up days to my down days. That's almost the entire determinant of a period for me. But what that has given me is that when I'm wrong, I just shrug and go, like, OK, well, I'm going to be wrong literally 50% of the days in 2020.
So how angry should I feel at the end of the day when I lose money? Really not angry at all, because that's just the nature of trading is that if you're constructing a process where 50% of the time you're wrong, but the other 50%, you're making 1.6x the losing days, if you know what I mean, then it gives you a little bit of peace of mind.
So I would strongly