Looking at your picture I believe you have the arm upside down. Turn it 180 degrees. But as others said take your line from the spool, through the hole in the metal flap and then down the hole. Every time you set this type of tip up is completely different depending on wind speed, direction, ect. When I used mind I also put a small bend on the metal flap to help catch a little more wind. You then bend the flag over and tuck it on the backside of the spool (creating resistance). When a fish strikes the whole arm will swing towards the hole and then the spool will begin to spin and trip the flag.
The only time I ever used the windlass tip-ups was for steel-head fishing on marinas on Lake Michigan in the winter. We also made plywood boxes around the holes and a cover with a small hole and slit for the line. They take some getting used to and aren't perfect but they do help with giving a small lure and or live bait some action (when wind exists).
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