The Disciplined Trader by Mark Douglas
Mark Douglas is the author of The Disciplined Trader: Developing Winning Attitudes, published in 1990 and considered an industry classic and one of the first books to introduce the investment industry to the concept of trading psychology.
Developing the Right Perception of the Market
Preventing Losses can't be done. The market is based on patterns & patterns repeat themselves, but not every time. So, there is no way to avoid losses or not be wrong. The Market is always right.
You can be wrong but never the market.
The market does not care about how much money you have lost or made. It has its own rhythm.
Through spending time in the market and through trying out different strategies and techniques you find out that the market has no emotions. Only us humans do!
The 3 Steps to Trading Success
Perceiving Opportunities -> Executing Trades -> Accumulating Profits
The above steps are influenced by human emotions which prevent us from winning a trade. One way we can manage our emotions or keep them in check is through a given set of rules. Everyone should create some basic rules and follow them in order to keep the emotions away from the trade. However, the rules must come from back tested & proven strategies. Developing rules from unsuccessful strategies can lead to immense losses.
Expectations & Goal Achievement
New traders tend to expect something like making 100$ every day or a 100% annual return. They tend to think about the result first and about the process at the last, which is completely wrong. We should remember that no man has reached success without feeling the pain of the slow process of study & preparation.
Study & Preparation -> Strategy -> Rules
This should be followed with discipline & it should be done mechanically without thinking about the reward.
The Monte Carlo Fallacy (Gambler's Fallacy)
The classic example of the gambler's fallacy occurs when someone flips a coin. If the head lands face up, say, four or five times, most people will believe that the coin will land on the tails side next time, occasionally even arguing that the repeated “heads” coin increases the likelihood of a future “tails” coin.
However, this is not true. Every time there is an equal probability of heads or tails appearing. Just like a coin does not have any memory, the candles in the chart have no memory.
When you finally accept that every trade has an equal probability of winning and losing your frustration with trading will end.
Building Failure Into the System
Once you accept that you will face losses equally in your trades, try to make them as small as possible. Let us assume that you take 10 trades and your risk to reward was 1:2. For this example, we will assume that you come out of the trade when your loss reaches 50$ and book profits at 100$. Now considering the 50-50 probability of wins and losses, you took 10 trades in which you lost 5 & won 5.
Your Losses = 50 x 5 = 250$
Your Wins = 100 x 5 = 500$
Net P/L = 250$ in profit
For this to succeed, it is important that you cut down your losses. Else, they will eat up all your winnings.
Expectations & Probabilities
Before setting any expectations, we should test a strategy on a Macro level. Say, we test our above example in which we made 250$ a 100 times. In the first 10 trades, we might have faced losses 6 or maybe 7 times but on a macro trend say out of 100 times we ended up winning 55 times.
Once we understand the probability at the micro level then we can set our expectations