The Disciplined Trader Developing Winning Attitudes Mark Douglas NEW YORK INSTITUTE OF FINANCELibrary of Congress Cataloging-in-Pub lication Data Douglas, Masi The disciplined trader: developing winning attitudes / by Mark Dougles. B. ca. ISBN 0 13-215757-8 1 Stockbrokers—Attitudes 2. Stock-exchange. I. Title HG4621 Dés 1990 332.64—de20 9.30237 ‘This publication is designed to provide accurate and authoritative information in regerd to the subject matter covered It is sold with the understanding thet the publisher is not engeged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought rom a Declaration of Principles Jointly Adopted By a Commits of he Americ Bar Asoctaon ancl Commitee of Pibishers and Associations 1990 by Mack Douglas ‘All sights seateved No part of this book may Panlssoninwntngion the pales Printed inthe United States of America 1098 New York Insitute of Finance ‘A.divison of Simon & Schuster. Ine 2 Broadway New York. NY 10004-2207To Paula Webb for her love, understanding and being there throughout the process of writing this book.Contents Foreword Preface Acknowledgments PartI Introduction 1 WhyI Wrote This Book 2 Why a New Thinking Methodology? Part II The Nature of the Trading Environment from a Psychological Perspective w The Market Is Always Right 4 There Is Unlimited Potential for Profit and Loss 5. Prices Are in Perpetual Motion with No Defined Beginning or Ending The Market Is an Unstructured Environment In the Market Environment, Reasons Are Irrelevant 8 The Three Stages to Becoming a Successful Trader aa Part II Building a Framework for Understanding Ourselves 9 Understanding the Nature of the Mental Environment Boa 15 24 37 39 41 43 56 61 72 7610 How Memories, Associations, and Beliefs Manage Environmental Information 11 Why We Need to Leam How to Adapt 12 The Dynamics of Goal Achievement 13 Managing Mental Energy 14 Techniques for Effecting Change PartIV How to Become a Disciplined Trader 15 The Psychology of Price Movement 16 The Steps to Success 17 A Final Note Index 88 105 119 132 141 151 152 166 184 185Foreword My unique position in the financial community has allowed me the rare opportunity to talk to and question thousands of traders, brokers, and trading advisors since 1979, I am not a broker or a letter writer. I am the chief executive officer of CompuTrac, a company that supplies technical analysis to stock and futures traders. I perceive my position as being neutral, one that allows people to open up and talk to me freely. I started trading for my own account in 1960 and very quickly became aware of the underlying psychological blocks to good trading and money management. This realization has been confirmed by all who have counseled with me. ‘As aresult, I sincerely feel that suecess in trading is 80 percent psychological and 20 percent one's methodology, be it fundamental or technical. For example, you can have a mediocre knowledge of fundamental and technical information, and if you are in psychological control, you can make money. Conversely, you may have a great system, one that you have tested and has performed well for a long period of time, yet if the psychological control is not there, you will be the loser. ‘A good trader knows from experience that over a period of time he may engage in more losing trades than winning ones. But money management, and a careful assay of the risks protected by realistic stops, will keep the trader out of trouble and ensure that on the "big" moves, he will profit. Money management is composed of two essential elements: psychological management and risk management. Risk management stems from the psychological factors being truly understood by the trader and "in place” before risk is even considered. 6I would especially caution new traders and market participants that reading and passively analyzing your motivations are certainly a necessity, but the acid test comes with active trading under pressure. Start slowly. Question every trade, What motivated it? How was the trade managed? Was it successful? Why? Did you lose? Why? Write down your assessment and refer to your comments before making your next trade. At all major CompuTrae seminars I try to have a workshop leader address the attendees on the psychological aspects of trading. The grim reaper who kills off "your equity” and disappears with your profits is not the mysterious and ubiquitous “they” but a simple misguided "you." Medea said just before she murdered her children, "I know what evil I'm about to do, but my irrational self is stronger than my resolution.” If this sentiment reflects your mind set when you trade, then The Disciplined Trader is definitely the type of book you should be reading What a pleasure to read this book. My own education cost me a lot "the hard way." I can read myself into the pages - that's me, that's me! Mark has carefully fashioned his book into a comprehensive logical dialogue. It reads as if you are at his side and he is explaining it as a friend, which I know you will enjoy. You are fortunate because you are taking the time now, before you have made a serious mistake, I hope, to leam about yourself and to study your craft. The traders who take the time to reflect and practice will survive and possibly prosper. TIMOTHY SLATER President CompuTrae Software, Inc.Preface The Disciplined Trader is a comprehensive guide to understanding the psychology of self-discipline and personal transformation needed to become a successful stock or futures trader. This book will serve as a step-by-step guide to adapting successfully to the unusual psychological characteristics of the trading world. I say “adapting” because most people venturing into the trading environment don't recognize it as being vastly different from the cultural environment in which they were brought up. Not recognizing these differences, they would have no way of knowing that many of the beliefs they acquired to enable them to function effectively in society will act as psychological barriers in the trading environment, making their success as traders extremely difficult to achieve. Reaching the level of success they desire as traders will require them to make at least some, if not many, changes in the ways they perecive market action. Unlike other social environments, the trading arena has many characteristics requiring a very high degree of self-control and self-trust from the trader who intends to function successfully within it. However, many of us lack this self-control because as children we leamed to function in a structured environment where our behavior was controlled by someone more powerful than ourselves, whose purpose was to manipulate our behavior to conform to society's expectations. Thus, we were forced by extemal forces to behave in certain ways through a system of rewards and punishments. As a reward, we would be given the freedom to express ourselves in some desired manner. As a punishment, we 8would cither be prevented from getting what we wanted, causing emotional pain, or we were inflicted with various forms of corporal punishment, causing physical pain. As a result, the only form of behavior control that we typically leamed for ourselves was based on the threat of pain - cither emotional or physical - from someone or something we perceived as having more power than ourselves. And since we were forced to relinquish our personal power to other people, we naturally developed many of our traditional resources for success (the particular ways in which we leamed to get what we want) from the same mental framework, Accordingly, we learned that acquiring power to manipulate and force changes upon things outside of us was the only way to get what we wanted. One thing you will learn as a trader is that the mental resources you use to get what you want in your everyday life will not work in the trading environment. The power and control that are necessary to manipulate the markets (make them do what you want them to do) are beyond all but a handful of individuals, And the external constraints that exist in society to control your behavior don't exist in the market environment. The markets have absolutely no power or control over you, no expectation of your behavior, and no regard for your welfare. If, in fact, you can't control or manipulate the markets and the markets have absolutely no power or control over you, then the responsibility for what you perceive and for your resulting behavior resides only in you. The one thing you can control is yourself. As a trader, you have the power cither to give yourself money or to give your money to other traders. And the ways in which you choose to do this will be determined by a number of psychological factors that have little or nothing to do with the markets And this will be so until you acquire some new skills and also learn how to adapt yourself to suit conditions as they exist in the market environment. To operate successfully in this environment you will need to leam how to control yourself in ways that may be completely alien to you. You will also have to lea how to grant yourself the mental freedom to shift your perspective to notice alternative possibilities to getting what you want in the trading arena, regardless of your expectations of how you are going to get it. There are only a few traders who have come to the realization that they alone are completely responsible for the outcome of their actions. Even fewer are those who have accepted the psychological implications of that realization and know what to do about it. Rarely do any of us grow up leaning how to operate in an arena that allows for complete freedom of creative expression, with no external structure to restrict it in any way. In the trading environment, you will have to make up your own rules and then have the discipline to abide by them. The problem is, price movement is fluid, always in motion, quite unlike the highly structured events that most of us are accustomed to. In the market environment, the decisions that confront you are as endless as the price movements you intend to take advantage of. You don't just have 9