What is the money flow index (MFI)?
The money flow index (MFI) is a momentum indicator utilised in technical analysis that measures the flow of money into and out of an asset, analysing both price and volume over a certain period of time.
Put differently, the MFI is a technical oscillator that identifies overbought and oversold signals insecurity.
It is also referred to as the volume-weighted Relative Strength Index (RSI) because it is related to the Relative Strength Index (RSI). However, the MFI incorporates both price and volume, unlike the RSI, which only includes price.
The dynamics of the money flow index
Values obtained from the MFI’s calculation are plotted as a line that oscillates within a range of zero to a hundred. Values obtained indicate overbought or oversold signals. A rising MFI indicates an increase in buying pressure. Conversely, when the MFI dips, it signals an increase in selling pressure.
When the MFI reading is above 80, the asset would be considered overbought, signalling a positive money flow. A value of 20 or below is an indication of selling pressure, signalling a negative money flow.
If the MFI rises above 90, it is viewed as a genuine overbought condition and a below 10 MFI is considered a really oversold condition.
However, the values of 80 and 20 are subjective and a technical analyst can set whichever levels they choose.
The oversold and overbought levels may change depending on market conditions. Generally, oversold and overbought levels are not reason enough to buy or sell. Traders should consider additional technical indicators to confirm a security’s turning point.
Keep in mind, the MFI may remain overbought or oversold for extended periods during strong trends.
Other than overbought and oversold conditions, the money flow index can also generate contradictory signals, such as divergences and failure swings.
Divergence
MFI divergence occurs when there is a contradiction between what the price action signals and what the MFI is indicating. If the underlying price makes a new high or low that is not confirmed by the MFI, the divergence can indicate an impending price reversal.
There are two types of divergences in this context, bearish and bullish.
- Bullish MFI divergence
When the price plunges to new lows, but the MFI makes a higher low, which could be an indication of an impending buying pressure. If they act quickly, traders can use the opportunity to buy securities at low prices.
- Bearish MFI divergence
When the price is making new highs, but the MFI makes a lower high, signalling there may soon be a selling pressure. This is an opportunity for sellers to gain profits.
It is beneficial to keep in mind that a divergence does not necessarily result in a reversal. The MFI can create misleading signals, occurring when the indicator signals a good trading opportunity, but the asset price does not move as expected.
Failure swings
Failure swings are completely independent of price and rely solely on the MFI. They are also considered as occurrences which can lead to price reversals.
Failure swings are considered to be either bearish or bullish and comprise four steps.
- Bearish MFI failure swing – indication of selling opportunity
- MFI rises above 80 (considered overbought).
- MFI dips below 80.
- MFI rises slightly but stays below 80 (stays below overbought).
- MFI drops lower than its previous low.
- Bullish MFI failure swing – indication of buying opportunity
- MFI moves below 20 (considered oversold).
- MFI bounces back above 20.
- MFI decreases but remains above 20 (stays above oversold).
- MFI breaks out above its previous high.
Calculating the money flow index
Usually, online platforms calculate the MFI automatically. However, understanding the steps involved in the calculation is a useful way to understand what the technical indicator is indicating. The steps to calculate the MFI are:
- Calculate the typical price for a trading period
To calculate the typical price, the average of the high, low, and closing price is to be ascertained.
The formula for calculating the typical price is:
Typical price = (Low + High + Close)/3
- Calculate the raw money flow
Simply put, the raw money flaw is the estimation of how much money has flown through a market in a given period, whether it was buying the security or selling it. The formula is:
Raw money flaw = Volume x Typical price
- Determine the positive and negative money flows
If the typical price for the period is higher than the previous period, it signals a positive money flow. Conversely, if the typical price is lower than the price of the previous period, it is considered a negative money flow.
- Calculate the money ratio
Add up all the positive money flows over the last 14 periods and divide the sum by the sum of the negative money flows for the last 14 periods.
The formula looks like this:
Money ratio = Positive money flow (last 14 periods)/Negative money flow (last 14 periods)
- Calculate the money flow index (MFI)
To calculate the money flow index, the following formula is used:
Money flow index = 100 – [100/ (1 + Money ratio)]
The MFI will be positive if the security’s price has mostly risen during the 14 periods, signalling buying pressure. Contrarily, the MFI will be negative if the price has mainly declined, indicating selling pressure.
The importance and benefit of the MFI in trading
The money flow index enables a trader to identify potential price reversals when overbought and oversold situations are indicated.
It can be a key indicator of the market sentiment with regard to security, as the MFI can indicate trader enthusiasm or lack of interest.
The MFI is considered a leading indicator, utilised to predict price movements on which a trader can act in good time.
However, keep in mind that leading indicators are not entirely accurate. Therefore, the MFI should always be used in combination with additional indicators to increase its effectiveness. In addition, a suitable risk management strategy should be in place.
Note: This article does not intend to provide investment or trading advice. Its aim is solely informative.
Top 4 Brokers
