How to use Broken Window Theory in your trading

Broken window theory got a lot of press back in the 80s and 90s, when New York City implemented its principles to help reduce crime. But it became highly controversial, as it fed into Giuliani’s zero-tolerance policy and the mass use of stop-and-search. And it’s linked to many of the heavy-handed policing policies that are coming under fire in Ferguson, Missouri.

But the premise behind it is a simple one … if you don’t fix the broken windows in your building, it’s more likely to get vandalized. The solution to preventing vandalism is to fix problems when they’re small. Repair a broken window within a day or two, and vandals are less likely to cause more damage.

It’s the same thing that’s happened to my house … neglect a building for long enough, and people become less and less likely to give it the TLC it badly needs.

And broken window theory also applies to our finances.

How to use broken window theory in your trading

The pile of statements that need to be filed … the trades we should be logging … the results we should be checking … the trading journal we need to update … the new strategy we should be testing but haven’t yet opened the manual …

It’s a failure to keep up with all the little ‘maintenance’ jobs that put us on the back foot. You may think that ‘the market’ hasn’t noticed that you’ve got lax – but you can be sure, it’s watching and waiting – as soon as it spots that broken window, it’ll set about vandalizing your account with a baseball bat and a can of spray paint.

As with all maintenance, it’s about little and often … and teaching yourself good habits.

Here’s a checklist to get you started. How often you need to do these tasks will depend on how regular and prolific a trader you are. If you’re placing several trades per day, you’re going to need to spend more time on maintenance than someone trading once a month …

Part of your daily routine (this needs to be habit) …

Update your trading journal. ‘What journal?’, you ask – this one.

Weekly or monthly, you should …

Tot up the figures in your trading journal – how’s your success rate doing? How’s your risk-reward profile doing? What about your positive expectancy? (Don’t know what I’m talking about? Check out these posts)

Test out the new strategies you’re waiting to try – do you have a strategy that’s sitting on the shelf, waiting to be tested – schedule some time in to test it out.

Read through your trading journal to judge what is working and what isn’t. Then formulate a potential plan of action to improve performance.

Test out strategy tweaks you’ve been thinking about. Do you think that adding an oscillator to your entry criteria could improve returns – start trialing it in a demo account. Do you want to see if trailing stops could improve your performance? Again, set up a demo account, and test it out.

Quarterly, don’t forget to …

Reassess the funds allocated to your trading strategies – do you want to reduce funds in a system that’s going through a rough patch, or add profits to your trading pot? Do you want to siphon off some profits to an investment with a different risk profile. Will you be taking an income from your trading fund? (By taking out, say 50% of gains each quarter or year, you can protect these profits.) Will you then reduce your position sizes to reflect the new, reduced bank? (These shouldn’t be spur of the moment decisions – they should be part of your plan.)

How many trades are you placing? Is this too many? Or too few? Most of us are guilty of overtrading – cutting out weaker trades is one of the best ways to improve your success rate and overall profitability.

How much are you risking on your trading strategies? Is it too much? Too little?

How long are you holding your positions for? Is this too long? Or are you jumping out to soon.

Are you happy with your broker/brokers? Even if you are, it’s worth checking what else is out there – other brokers may have special offers on, or have lower costs.

Year end …

Assess your objectives – why are you trading? Is it for long-term wealth, a regular income, mental stimulation? What do you want to achieve?

Look at your returns – are they in line with your expectations? Are your expectations realistic?

If you experience a run of losing trades, how will you react? What percentage will you tolerate losing before you stop trading temporarily? For example, if you’re down 10% for the month, you could cut your position size in half for the rest of the month. If you’re down 15%, you might stop trading for the rest of the month. If you’re down 25%, it could be time to take a 4-week break from trading. I can’t stress enough how important it is to have a plan in place – otherwise, traders tend to ‘close their eyes’ to the situation, and can too easily wipe out their fund. Losing runs WILL happen – it’s part of trading.

Has your trading plan covered all eventualities over the past year, or have you found yourself ‘winging it’? Take a look at your plan and add to it where necessary.

How much time are you spending trading? Are you being distracted in your trading – how can you avoid this?

Are there psychological weaknesses that are letting you down? How will you beat these bad habits? What are strengths and how can you best exploit them?

How will you measure success over the coming period? Profitability? Win rate? Beating bad habits? Reducing volatility of returns? Success is more than just the bottom line – you want to consider your long-term growth as a trader.

I hope this list hasn’t seemed too daunting – making these maintenance checks part of your trading routine should help you keep on top of things – and stop the markets vandalizing your account!

Any more ideas of what should be key parts of your routine maintenance, please add them below.

Related posts:

The trader’s essential maintenance checklist Your trading checklist