Summer Reading List: Mark Douglas’ Classic Guide to Trader Psychology

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"One of the many contradictions of trading is that it offers a gift and a curse 
at the same time. The gift is that, perhaps for the first time in our lives, 
we're in complete control of everything we do. The curse is that there are no 
external rules or boundaries to guide or structure our behavior." 
- Mark Douglas Trading in the Zone: Master the Market with Confidence, 
Discipline and a Winning Attitude.

Our last book review was all about stocks. This one is all about you — the trader.

The passage above sets the tone for Mark Douglas’ classic work on psychology and mental preparation, Trading in the Zone: Master the Market with Confidence, Discipline and a Winning Attitude. It’s not about how to trade or what to trade. It’s about how to think when trading. And, how not to think.

Douglas draws on years of experience in futures pits and coaching professionals to reach several key conclusions about making money in the market. His book contains so many valuable insights that it’s difficult to summarize them in a single article, so this review will try to focus on the most basic points.

The first key point is that financial markets differ from almost every other social environment you know: work, family and friends. Those settings have basic manners to protect people’s feelings and emotions. Even if someone disagrees with you or your boss orders you to do something, you expect them to follow certain basic courtesies.

Another difference is that your work doesn’t matter. A developer might spend a week coding an application. At the end of the time, something real and valuable will exist. This link between work and outcome is true for most things in life, but not in trading. In the market, outcomes have no direct link to your effort.

Overcoming Fear

Douglas isn’t saying that you shouldn’t try. He’s simply highlighting that trading is very different than most other activities. Therefore, traders need to think differently. As he says at the start of chapter 4, “what separates the best traders from everyone else is not what they do or when they do it, but rather how they think about what they do and how they’re thinking when they do it.”

So what are those ways of thinking? One of them is overcoming fear. Douglas lists four primary fears:

  1. Fear of being wrong
  2. Fear of losing money
  3. Fear of missing out
  4. Fear of leaving money on the table

It’s not by accident that “fear of being wrong” is the top item on the list. Trading in the Zone often stresses how this worry — an injury to our pride — can blind us to to reality. It can make us stick in losing stocks and prevent us from capitalizing on opportunities we might not have expected.

Another problem is that many people attempting to trade come from successful professional backgrounds: doctors, lawyers, executives. They’re accustomed to being right and being in charge. They’re also not afraid of hard work. So they spend a lot of time learning about the market. Douglas views this as a common trap of falling into market analysis.

Taking Responsibility as a Stock Trader

While analyzing the market is useful, Douglas says it can prevent traders from taking responsibility for their actions. It makes them think they need to understand more instead of trading better. Market analysis does have a purpose for developing an edge, which we’ll cover below.

Trading in the Zone says that taking responsibility as a trader “means believing that all of your outcomes are self-generated.” Failure to take responsibility in this way will push you into an adversarial relationship with the market and drive you deeper down a rabbit hole of market analysis.

Another reason why traders need to take responsibility is that they can only control their own behavior and trades. They cannot control the market. This is different than a lawyer or a doctor, who can control his legal case or her patient’s health. Traders must take what the market gives them and never question it:

"Every trader I've worked with over the last 18 years has had to learn how to 
train his mind to stay properly focused in the 'now moment opportunity flow.' 
This is a universal problem, and has to do both with the way our minds are 
wired and our common social upbringing."

Thinking in Probabilities

Because the trader can only control himself or herself, Douglas emphasizes the need to think in probabilities. The trader must not care if they’re right or wrong with any individual trade. All that matters is following their system consistently. That way probabilities will favor him or her over time. (This is also dependent on having a reliable “edge,” mentioned below.)

Being open about the market lets traders see the possibilities their pre-conceived beliefs might block. Meanwhile, strictly following rules lets them manage risk and enter positions consistently. It also lets them rein in the one thing that is under their control: their own actions.

This brings me to my favorite quote in the book.

"We need to be flexible in our expectations so we can perceive, with the 
greatest degree of clarity and objectivity, what the market is 
communicating to us from its perspective. The typical trader does 
just the opposite: He is flexible in his rules and rigid in his expectations.
(Emphasis added.)

You might want to write in on the wall!

Douglas then spends several chapters on how to overcome stubborn beliefs entrenched in our minds. It’s one of the most valuable parts of the book, and hardest to implement. It’s worth reading on your own, but the main idea is that successful traders must “deactivate” entrenched beliefs about the market and develop beliefs about themselves. Again, he points the mirror right back at the reader, saying to worry less about the market doing crazy things, and more about yourself doing crazy things.

Trading Edge

One of the few drawbacks of Trading in the Zone is that Douglas compares trading to operating a casino. His point is valid because casino games like roulette have odds favoring the house. A better example could be a grocery store that sells certain products at a loss, like milk, in hope of profiting on other items like cereal and soda.

A grocery won’t refuse to serve you because you’re only buying a gallon of milk. Even if it doesn’t make money, it has a viable business model. Once a critical mass of shoppers pass through their doors, the probabilities add up in their favor and they make a certain margin consistently.

That mix of products is similar to the trader’s edge, which Douglas defines as “nothing more than an indication of a higher probability of one thing happening over another.”

He spends barely any time discussing all the potential edges traders might use. But they could include things like moving-average crosses, support and resistance or trend following. William O’Neil’s entire book can be viewed as a single type of edge based on cup-and-handle patterns. As readers of Market Insights and viewers of my webinars know, my personal favorite type of edge uses sector performance. I try to focus on companies in groups and industries that are outperforming the S&P 500.

Regardless of the edge, you must realize there are times it won’t work. Douglas also emphasizes the importance of acting on your edges when you have them. He urges readers to identify them objectively and act on them without reservation. In other words, don’t fear buying a stock chosen by your system because the last one lost money.

Limitations of Trading in the Zone

Trading in the Zone is a seminal work for trader psychology and education. It brilliantly shifts the focus from the uncontrollable market to the controllable and trainable individual mindset. It also describes how subjective forces like fear and beliefs can impede objectivity.

These are important insights for anyone looking to consistently make money in the market to realize.

However readers must be careful not to take his idea of being “open to everything” too seriously, or to reject market analysis. After all, there are deeper trends and patterns in the market. Right now, it’s a shift toward cloud computing, e-commerce and weak-dollar trades. Knowing and understanding these forces can help shape your edge. (Especially if you use RadarScreen® to adjust when changes occur.)

Second, many customers may not be traders. If you’re more of a longer-term buy-and-hold investor, Douglas’ concepts may not be suited to you.

In conclusion, Trading in the Zone is one of most famous trading books of all time. It’s well worth the read — especially if you find yourself repeating mistakes. Believe it or not, other people have been down the same road. And this book has helped many of them become consistently profitable traders.

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David Russell is VP of Market Intelligence at TradeStation Group. Drawing on nearly two decades of experience as a financial journalist and analyst, his background includes equities, emerging markets, fixed-income and derivatives. He previously worked at Bloomberg News, CNBC and E*TRADE Financial. Russell systematically reviews countless global financial headlines and indicators in search of broad tradable trends that present opportunities repeatedly over time. Customers can expect him to keep them appraised of sector leadership, relative strength and the big stories – especially those overlooked by other commentators. He’s also a big fan of generating leverage with options to limit capital at risk.