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2024/06

Tips and insights to avoid the “Broken Window Effect” in trading

Ignoring a small loss, leading to larger losses, and eventually becoming deeply trapped or even facing a margin call is a phenomenon known as the “broken window effect.”

The broken window effect refers to a situation where a negative impact (A) in a system triggers a chain reaction, causing more negative impacts (B, C, D, etc.), ultimately leading to the collapse of the entire system.

In the trading world, the “broken window effect” manifests when traders disregard an initial loss and allow themselves to continue making mistakes, thereby increasing their losses. Eventually, traders may adopt a careless attitude, operating more arbitrarily and becoming increasingly irresponsible with their accounts, thus falling deeper into the abyss of losses.

Interestingly, a novice with no trading experience may find it easier to make money than a trader who has suffered deep losses, which is also a part of the “broken window effect.” This effect reveals a psychological inertia where, once an account experiences deep losses, a person is likely to develop a “give-up” mentality.

Therefore, in daily trading, it is essential to be vigilant and avoid easily breaking the “funding window.”

To prevent the broken window effect, traders should pay attention to the following four points:

1. Do Not Break the "Funding Window"

The “funding window” refers to avoiding significant losses in a trading account. If a trade unfortunately results in a substantial loss, it is crucial to exit the position decisively. Refrain from entertaining the idea of recouping the loss immediately, which could lead to more profound losses.

It is best to set a stop-loss point in advance for potential losses. If you experience a significant drawdown after floating profits, the stop-loss point should at least be above the breakeven price.

This prevents your profitable positions from turning into floating losses, thus avoiding being trapped. Many people hesitate to close at breakeven, fearing prices might rebound afterward. However, using limited capital to seek countless future opportunities is not wise.

The “funding window” refers to avoiding significant losses in a trading account. If a trade unfortunately results in a substantial loss, it is crucial to exit the position decisively. Refrain from entertaining the idea of recouping the loss immediately, which could lead to more profound losses.

It is best to set a stop-loss point in advance for potential losses. If you experience a significant drawdown after floating profits, the stop-loss point should at least be above the breakeven price.

This prevents your profitable positions from turning into floating losses, thus avoiding being trapped. Many people hesitate to close at breakeven, fearing prices might rebound afterward. However, using limited capital to seek countless future opportunities is not wise.

2. Timely Repair of the Broken "Funding Window"

If the “funding window” is broken, the best stop-loss strategy is to pause trading decisively. Do not hold onto the hope of recouping losses by holding positions indefinitely. In non-leveraged stock market investments, many hold onto this false hope and end up deeply trapped.

When losses occur, it is crucial to remedy them immediately—repair the damage proportionally to the loss. Temporarily exiting the market to identify the root cause of mistakes or losses, fixing the window, and readjusting your mindset before re-entering the market is the most sensible approach.

3. Resist the Temptation of Poor Trading Signals

Adhering to the correct principles and direction and sticking to your trading system is crucial. Do not be swayed by poor signals in the market. Unthinkingly following trends or chasing highs can easily lead to significant losses or becoming deeply trapped.

Many investors are drawn to popular products, especially in the stock market. When a stock shows a promising uptrend, investors might unthinkingly follow, only to regret it when the stock plummets. Thus, investors should make investment decisions based on their circumstances and market conditions.

4. Maintain a Good Trading Mindset

According to the broken window theory, a trader’s single mistake can be magnified, gradually causing the trading mindset to become unbalanced due to failures or severe losses. Novices or those who have not experienced significant losses tend to be more cautious, reducing the likelihood of major mistakes.

However, once a trader experiences significant losses, failing to adjust their mindset and trading strategy could lead to more severe subsequent losses. Therefore, traders must maintain a good mindset and rationally address losses in trading.

Conclusion

Among the above points, the third is particularly crucial, as the market often employs the “broken window theory” to mislead investors.

In summary, if a window is broken and not repaired, more windows will likely be broken afterward. The correct approach is to identify risks early and eliminate them at the outset rather than letting them escalate.

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