How to Use the Concept of Mean-Time-to-Failure When Trading

By L.A. Little  SEP 21, 2012 11:30 AM

MTTF can tell you where price might go.

 


MINYANVILLE ORIGINAL Yesterday multiple indexes tested swing point highs and failed. That is a reasonably good sign that some sort of retrace is about to unfold. There’s another indication that the probability of a retrace is upon us as well, and that has to do with knowing how long the current trend has been in place. Not only does it tell us that a retrace is highly probable, but it also provides us with a measure of the minimum amount it needs to retrace. Let me explain.

The method that I speak of is a concept I borrowed from engineering. It is outlined in my new book, Trend Trading Set-Ups. It is based on the concept of mean-time-to-failure (MTTF). In engineering circles, MTTF is used extensively to understand expected product life cycles. To do this, samples are taken, statistics are drawn, and MTTFs are produced. If you think about qualified trends as having life cycles, then why not think about the MTTF of that life cycle? It’s very easy to do, and it is useful as well.

Here's a chart of the short-term time frame of the S&P 500 (INDEXSP:.INX). The trend transitioned to bullish on June 15 and has remained in that state ever since. That was 47 bars ago.


Source: www.stockcharts.com

Note that 47 bars is a rather long time for a short-term trend to persist. If you look at the data, the cumulative probability of a trend failure for a short-term suspected bullish trend of this duration is very high. In fact, it's approaching the 80th percentile, as shown below.


Source: www.stockcharts.com

For the MTTF to reset, the trend needs to transition from bullish to sideways. It can only do that by trading and closing under a prior swing point low. The nearest one at this juncture is the August 10 low of 1395.62 as shown below.


Source: www.stockcharts.com

That's another 18 or so points from yesterday's close. I expect that is where we are headed now. It also lines up nicely with the anchored support zone created by the conjunction of the tops of the July 27 and August 3 anchor bars. That's the first target area. Assuming price makes it there and volume doesn't swell precipitously, that's likely the place to put additional long exposure back on and reduce or eliminate any short exposure you are riding back down. If volume and price don’t behave at that level, then the next anchor zone would be in play, and I doubt it will be easily cracked. That price point is the 1360 area, and the anchor zone there looks quite strong.

One last note before signing off: On Monday, I began telling my readers to expect a retrace and to position short in preparation for it. It’s not all that often that everything lines up as cleanly as it did this time. MTTF can not only tell you where price might go, but it can also give you a clear heads-up about when you move to safety for the trade coming back the other way. In this case, it aligned with a test of swing point highs on multiple indexes with light volume. That was a high probability trade, and is what you should always be seeking.

Twitter: @tatoday
No positions in stocks mentioned.