Hi folks. I’m here today interviewing Mark Douglas, the author of Trading in the Zone. Mark, whom I’ve known for several years, is an authority on the psychology and discipline it takes to achieve long-term success as a trader. He has helped thousands of traders improve their trading performance by overcoming self-defeating behaviors. I truly believe Mark to be a credible source of information on this topic because he himself is a trader. He built his mental strategies on the foundation of having successfully fought his way back from his own initial shortcomings as a trader. Now let’s get down to business.

Eddie Kwong: How are you doing, Mark?

Mark Douglas: Tired. Very tired. These hockey games wipe me out. The average age on the team is probably about 27 or 28. And I’m in my 50s.

Kwong: Wow, that’s incredible. So do you find that staying physically active helps your mental focus trading?

Douglas: Oh, sure. Absolutely there’s a correlation. People should stay physically fit no matter what they do, Eddie. I’m not saying they should play ice hockey. It just so happens I played organized hockey in high school. The last time was 1966. But I didn’t play again until 1995. So I was off for about 28 or 29 years. It was strange getting back into a team, competitive sport, when I hadn’t played since I was a kid. After all those years, it took me probably about 2 to 2½ years to get adjusted to it.

Kwong: So Mark, tell me how you got started in the business. I recall reading The Disciplined Trade and it told a little bit about your background. How did you start trading and how did you get involved in trading psychology and discipline?

Douglas: I was in the commercial casualty business around 1978 and I got a call from a broker. Probably like many people, I was bored with what I was doing. I always thought that managing an insurance agency was something I really wanted to do. And I was very successful at it, but not particularly challenged by it, at least at that point.

I got that call from a broker, and opened up an account. Another odd thing about my trading career is I started trading futures right off the bat. It never occurred to me to trade stocks. I can’t really tell you why. It just didn’t. And I think the first trade I put on was a potato futures trade when they used to trade potatoes at the Chicago Mercantile Exchange. And then from there, I started trading gold and silver, mostly.

Kwong: And how did you do?

Douglas: Oh, typical. You make money in the very beginning. You know, you put on “X” number of winning trades, however many it takes to get into your blood; the winning trades, the exhilaration, the euphoria. And at some point, you start making mistakes; you start doing things that are counterproductive to what it means to be a consistently successful trader. Of course you don‘t know it at the time. But it all seems very easy, like your panacea of instant wealth is right before your eyes.

And like most people, I had winning trades and then losing trades, and losses to the point where I lost my initial stake. I saved up some more money and lost that and then saved up some more money. And what really got me--and this is something that’s not in my book--what really got me involved in the business was just before silver made the big run-up to $49 an ounce around 1979 or '80. I was long two, 5,000-ounce contracts of silver at around 9.60 an ounce or 9.68. And the market dropped about 20 cents. And my broker said, “Well, you know, you don’t want to get out of this position. So what I’m going to do is spread you – put on a spread between New York and Chicago.”

So he sold 10,000 ounces in New York. So I was at about a 20-cent spread where I was short New York and long Chicago. And he said when the market went back in my favor, he’d take the short end of the spread off. And so what happened is that the market rallied about 20 cents and then he took the short end of the spread off and then it dropped another 15 or 20 cents and he put the spread back on. And then the market rallied again and he took the short end of the spread off and then it dropped another 15 or 20 cents and he took the short end. And then he put it back on. And he kept locking in deeper and deeper losses. And I didn’t know what I was doing and I didn’t know that he didn’t know what he was doing either other than just generating a lot of commissions.

And eventually it got to the point where all my equity was gone and I couldn’t sleep. And it was really disturbing. I mean basically the silver market at the time was just in a 20-cent range and he was buying the high end of it and selling the low end of it. It was crazy. But like I said, I didn’t really know what I was doing. And so I just kind of woke up and decided that I was just going to blow out of the whole position. So I called him up and I did. And of course that was the day that the market rallied.

Kwong: Oh, man. Sounds like a defining moment in your life.

Douglas: Yeah. And that was the day that it started shooting up to $49 an ounce. And I’m thinking to myself, I could have made $400,000. I mean at the time -- again, not knowing the dynamics of what it means to be a successful trader -- I’m thinking that I was sitting on $400,000 and I was that close to it. And from that point on, I mean I was really hooked.

Kwong: That horrible experience got you hooked?

Douglas: Yes. I blew out of the whole position. I blew out of the whole spread. I mean it was just – you know, all my equity was gone and I was looking at losses and margin calls at that point.

Kwong: Did you just want revenge on the market?

Douglas: No.

Kwong: Then were you determined to succeed no matter what?

Douglas: Yes. Right. But I’ve never been a revenge trader. That never occurred to me to get revenge on the market.

Kwong: I see. Did this affect you psychologically and emotionally? Would you say that it was a productive sort of impact, in that it made you want to go back and do the research and analyze yourself, or did you find that it was debilitating?

Douglas: Yes, it was definitely debilitating because it was always on my mind. It was always swirling through my mind that I was that close to that much money and now I was in a situation where I couldn’t even trade because I didn’t have the money. Watching the market go all the way to $49 an ounce and thinking--erroneously--that I’d been able to stay in the trade to $49 an ounce was ludicrous because I didn't have the skills to be able to stay in a trade like that, at least at that time.

But I didn’t know that then. And so, yes, I found it very emotionally debilitating. But at the same time, it was also inspiring because I was determined to learn everything I needed to learn about what it meant to be a successful trader.

Kwong: So what did you do then? What did you do at that point?

Douglas: Being able to put on a winning trade and being able to produce consistent results and a steadily rising equity curve are two universes apart. And so I went on a knowledge quest. I started going to all the seminars, I started buying the books, and just dove right into it. I even got to the point where I sold out my interest in the casualty agency. I was thinking, hey, if I’m going to do this, I’ve got to do it where people are doing this and I can find out what’s going on. So I moved to Chicago and got a job with Merrill Lynch at the Chicago Board of Trade. I went into the brokerage business.

Kwong: I see. What kind of milestones can you think of that during the course of your educating yourself where you can look back and say those were the significant steps upward that you made, not only in increasing your knowledge, the type of knowledge that you teach people now, but also in proving your ability as a trader? Or did it just happen steadily?

Douglas: It just happened steadily. I don’t know if I’d call it a milestone, but one of the things that was kind of interesting was the first trading book I ever bought: Jake Bernstein’s Investors Quotient. I always inherently knew that trading was psychological.

Kwong: Yes, I read that book too.

Douglas: The group of people focusing-in on the psychology of trading back in the late '70s and early '80s was really small. Back then most of the trading community--especially the academic community and the Wall Street community--looked at technical analysis as a form of mystical hocus pocus.

Kwong: Yes, I remember that.

Douglas: We’ve evolved a lot in the last 20 years, haven’t we?

Kwong: Yes, exactly. Looking forward to the present, what did you learn that has had a major impact on you? What do you do differently now and what do you try to teach people?

Douglas: Well, what I teach people now is that there are four primary areas that have to be mastered to create consistent results. One is learning how to identify an edge, and that’s basically learning how to read the markets, right? Learning how to think in the market’s perspective. This is big. Learning how to think in the market’s perspective, which is in essence, learning how to think in probabilities. Learning how to identify and neutralize self-sabotaging beliefs. And before one is going to learn to identify and neutralize self-sabotaging beliefs, they have to have some awareness of how beliefs act on their perception of information and their behavior in a way that can cause them to do things that lose money--whether they are conscious of it or not.

They have to come to that point to realize the inner dynamics of how their beliefs interact with the market environment, and how to monitor their susceptibility to euphoria. Because once you start winning and start winning consistently, if you don’t have a framework, if you don’t have a mental framework to at least be able to recognize when you cross the threshold into euphoria (and there is a difference between a normal state of mind where you’re in a state of confidence and when you cross the threshold into euphoria: once you’re in euphoria, you are in what I call a risk-less state of mind) than you cannot perceive risk.

Kwong: I see.

Douglas: That’s the difference. When you’re in the normal state, a normal confident state of mind, you do what you need to do when you need to do it. And all the boundaries and limitations that you have in place when you trade are all operative.

Kwong: Most people consider themselves to be competent in different things that they do, say as a doctor or lawyer. But when it comes to trading, they lose their nerve, or something knocks them off the horse. What happens?

Douglas: That falls into the second category of what people have to learn to be consistently successful. And that’s learning how to think in the market’s perspective or learning how to think in probabilities.

There’s a direct correlation between your ability to think in probabilities and your state of confidence as a trader. See, when you learn to think in probabilities, basically you’re taking a stance. Your perspective that you’re taking with the market is that I don’t need to know what’s going to happen next to make money. Every moment is unique.

Now if you operate from the perspective of believing that every moment is unique, what does the word uniqueness imply? That this next moment in the market is like no other that’s ever existed. It may be similar, but it’s truly unique, meaning that I don’t know what’s going to happen next. And if I believe that I don’t have to know what’s going to happen next but I also know that I have an edge--meaning that there’s a higher probability of one thing happening over another--and I also know that I know how much I have to risk to find out if that edge is going to work. And if I also have the confidence to know that I’ll cut my losses if the market behaves or indicates to me that that edge isn’t working, then what do I have to be afraid of?

One of the problems is the way we define success in society: that we’ve mastered the environmental forces. Now, what are those environmental forces? In any kind of profession, what I do to be successful at it is I master all the principles of success of that profession, right? In other words, I am in a state of knowing. And not only am I in a state of knowing, but let’s say I’ve also climbed the corporate ladder or some social structure in which I have power over other people and I can exercise that power: that’s what makes a person successful in those other chosen professions.

Then these otherwise successful people get into trading and find that they don’t have power over the market. And not only do they not have power over the market, but they don’t know what’s going to happen next, although they believe they can know what’s going to happen next. Now, if they’re psychic, they do. If they’re incredibly intuitive, they do. But even then, using your intuition in the market without the proper psychology will have disastrous results, not only financially but also psychologically.

So the whole point is that you will be confident when you truly accept and let go of the fact you don’t have to know what’s going to happen next to make money. So once that framework is in place, there’s nothing to be afraid of anymore. The less fear that you’re operating out of, the less fear that’s running through your body and running through your mind. Fear is an energy. The more confident I am, the less fear that there is.

As you approach this state of confidence, you’re able to interact with the market objectively. Objectively means that I do not have the potential to perceive the up-ticks, down-ticks, patterns, and market information as threatening. And the only way that I’m going to define market information in threatening ways is based on what I believe. If I believe that I think I know what’s going to happen next, than I have an expectation of what’s going to happen next. And see, the problem is there isn’t anything more painful than an unfulfilled expectation. So if the market fulfills my expectation, I feel great, right?

But if the market generates information that tells me that my expectations will not be fulfilled, then any number of things can happen. What normally happens is our mental defenses start coming into play, meaning we start blocking, rationalizing, or actually altering that information in a way where we think there is something else going on than what the market is actually telling us. And so now we’re operating in a state of illusion or delusion and therefore subject to any number of trading errors.

Kwong: Tell me something: One of the things that you probably encounter all the time is somebody approaches you at a conference or something and say, "you know Mark, I just bought this great, fantastic system. And in reading the brochure, that system looks like it will make all my decisions for me. And I’m willing to follow that system religiously and take all the buy signals and all the sell signals mechanically. So what do I need with a trading psychology approach?" What do you tell a person who is thinking that way?

Douglas: I don’t tell them anything unless they ask me.

Kwong: Okay--

Douglas: No, I really mean that, Eddie, because there isn’t any point in telling them anything because they’re going to find out on their own anyway.

Kwong: And what do you think they’ll find out?

Douglas: I don’t think. I know.

Kwong: What will they find out?

Douglas: Well, let’s put it this way: If they understand how technical systems interact with the way the market moves, if they understand those dynamics and they have the kind of personality that can actually execute this system as the rules were designed to be executed, then they really shouldn’t have a problem. The only problem they are going to have is if the system doesn’t generate a positive edge. You know that technical systems only have to be right even a little less than 40 percent of the time if they have a 3-to-1 reward-to-risk ratio.

But here’s the problem. Most technical systems – and this is where anybody is going to have a real problem because most technical systems can give you real good entry and exit points and define when the trade isn’t working-- you know exactly what your loss is. There are very few technical systems that have really mastered how to take profits, assuring themselves of getting a 3-to-1 reward-to-risk ratio.

It is very difficult to mechanize taking profits. And that’s where they are going to run into problems. What’s going to happen is that even if they execute their system perfectly in terms of entry, if they don’t understand how to take profits, they’re going to invariably end up leaving money on the table. And if they have any particular emotional problems with the idea of leaving money on the table, in other words, not realizing that it's just a function of the business, they'll start tweaking the system and they’ll probably start making trading errors.

Kwong: I’m sure this is exactly the experience many traders have when they first start out.

Douglas: Right. And Eddie, that was one example, right? Let’s take an example of someone who doesn’t really understand what’s going on and thinks that the system is going to tell them what’s going to happen next. That guy has no chance at all.

Kwong: I like you candour on that.

Douglas: See, the problem is that the system is going to be right a certain percentage of the time. But there’s a huge gap between understanding probabilities and actually thinking in probabilities. People have a normal aversion to taking losses. And if this person is normal and has a normal aversion to taking losses (has a normal aversion to being wrong), buys a system because he thinks that the system is going to tell him what’s going to happen next, and then takes a series of losing trades, well, what’s going to happen? He’s going to throw the system away.

I’ll give you an analogy. If I flipped a coin a thousand times, what’s my average distribution between heads and tails of a thousand flips? It’s going to be 50/50, right? That's a pattern. But within that pattern, meaning on an individual flip-by-flip basis, I will have several streaks where I might get heads eight times in a row or tails six times in a row, right? That’s exactly the way a technical system works: that over a large sample size of trades, I will have a system that gives me, say 60% winning trades.

The problem is on an individual, trade-by-trade basis, there’s a random distribution between wins and losses. And if I don’t really understand that, if I don’t really believe it – not just understand it, but believe it, then I will be susceptible to trading errors.

Kwong: I see your point very clearly. When people come to you, they ask for help, what are some of their most common problems?

Douglas: That’s it right there. What I do is I teach people how to think in probabilities because it virtually ends all these problems.

Kwong: I presume that most of this is contained in your new book, Trading in the Zone.

Douglas: Not everything, but a lot. I can give you four or five points that would really help.

Basically what Trading in the Zone does is this: I set out to prove to the trader that more or better market analysis is not the solution to his trading difficulties or lack of consistent results. I set out to convince a trader that it’s his attitude and state of mind that determine his results, to provide the trader with the specific beliefs and attitudes that are necessary to build a winner’s mind set, which means learning to think in probabilities so they can eliminate the potential to define market information in threatening ways and therefore eliminate their potential to make trading errors.

I also attempt to address the many conflicts, contradictions and paradoxes in thinking that cause a typical trader to assume that he already does think in probabilities when he doesn’t. That’s a big part of it too because most people understand probability from college or reading a book; they think that they are already thinking that way. In other words, that they’ve integrated that strategy at a functional level when they haven’t. And number five is to take the trader through a process that integrates his thinking strategy into his mental system at a functional level. That’s what Trading in the Zone does.

Kwong: Thank you for your insight, Mark.

Douglas: You're welcome, Eddie.

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