The Money Flow Index (MFI) is a technical oscillator that leverages both price and volume data to determine whether an asset is overbought or oversold. Additionally, it can identify divergences that may signal an impending trend reversal in the asset’s price. This oscillator operates within a range of 0 to 100.
Unlike traditional oscillators like the Relative Strength Index (RSI), which only considers price data, the Money Flow Index integrates both price and volume. This distinctive feature has led some analysts to refer to the MFI as a volume-weighted RSI.
What is the Money Flow Index?
The Money Flow Index (MFI) is a momentum indicator in technical analysis that assesses time and price to gauge trading pressure, whether buying or selling. Also known as the volume-weighted Relative Strength Index (RSI), the MFI incorporates volume data, setting it apart from the RSI, which only uses price information.
An increase in the typical price indicates a positive money flow, suggesting buying pressure, while a decrease points to a negative money flow, indicating selling pressure. These positive and negative money flows are accumulated to form the money flow ratio or money ratio.
The money ratio is then used to calculate the MFI, which oscillates between 0 and 100. Due to its inclusion of volume data, the MFI is effective in identifying price extremes and potential reversals, providing a variety of signals for analysts. You should first understand what is MFI indicator.
The Money Flow Index (MFI) can be calculated through the following steps:
1. Compute the typical price for a period:
Typical Price = (Low + High + Close) / 3
If today’s typical price is higher than yesterday’s, it indicates a positive money flow. Conversely, if it’s lower, it indicates a negative money flow. The sum of positive money flows over a set period results in the positive money flow, while the sum of negative money flows over the same period results in the negative money flow.
2. Compute the raw money flow
Raw Money Flow = Volume x Typical Price
3. Compute the money ratio
Money Ratio = 14-period Positive Money Flow / 14-period Negative Money Flow
4. Compute the Money Flow Index (MFI)
Money Flow Index (MFI) = 100 – [100 / (1 + Money Ratio)]
How to Calculate the Money Flow Index?
Here are the steps to calculate the Money Flow Index (MFI). It’s recommended to use a spreadsheet for manual calculations:
1. Calculate the typical price for each of the last 14 periods:
Typical Price = (Low + High + Close) / 3
2. Determine whether the typical price for each period was higher or lower than the previous period:
- If the typical price is higher than the prior period, the raw money flow is positive.
- If the typical price is lower, the raw money flow is negative.
3. Calculate the raw money flow for each period:
- Raw Money Flow = Volume × Typical Price
- Use positive values for periods where the raw money flow is positive.
- Use negative values for periods where the raw money flow is negative.
4. Calculate the money flow ratio:
- Money Ratio = Sum of positive money flows over the last 14 periods / Sum of negative money flows over the last 14 periods
5. Calculate the Money Flow Index (MFI):
- Money Flow Index (MFI) = 100 − [100 / 1 + Money Ratio]
6. Update the calculations as each new period ends, using only the most recent 14 periods of data.
By following these steps, you can maintain an accurate and up-to-date Money Flow Index to assist in your technical analysis.
What Does the Money Flow Index Tell You?
One primary application of the Money Flow Index (MFI) is identifying divergences, which occur when the oscillator moves in the opposite direction of the price. This indicates a potential reversal in the current price trend.
For instance, if the MFI is very high and then drops below 80 while the underlying security continues to rise, it signals a possible downside price reversal. Conversely, if the MFI is very low and then rises above 20 while the security continues to decline, it signals a potential upside price reversal.
Traders also monitor larger divergences using multiple price and MFI waves. For example, if a stock peaks at $10, drops to $8, and then rallies to $12, creating two successive highs at $10 and $12, but the MFI forms a lower high at $12, the indicator is not confirming the new price high. This could predict a price decline.
Overbought and oversold levels also provide trading signals. Moves below 10 and above 90 are uncommon, but when the MFI moves back above 10, it signals a long trade opportunity, and when it drops below 90, it signals a short trade opportunity.
Other transitions out of overbought or oversold territory can also be useful. For example, in an uptrend, if the MFI drops below 20 (or even 30) and then rallies back above it, it could indicate the end of a pullback and the resumption of the uptrend. In a downtrend, a short-term rally might push the MFI to 70 or 80, but when it drops back below that level, it could be the time to enter a short trade in anticipation of another price drop.
The Difference Between the Money Flow Index and the Relative Strength Index (RSI)
The Money Flow Index (MFI) and the Relative Strength Index (RSI) are quite similar, with the key difference being that the MFI incorporates volume data, whereas the RSI does not. Advocates of volume analysis view it as a leading indicator, believing that the MFI can provide signals and warn of potential reversals more promptly than the RSI. While neither indicator is inherently superior, they each incorporate different elements and therefore offer signals at varying times.
Limitations of the Money Flow Index
It’s important to note that the MFI can produce false signals. These occur when the indicator suggests a favourable trading opportunity, but the price fails to move as expected, resulting in a losing trade. For instance, a divergence might not always lead to a price reversal.
Additionally, the MFI Index might not always warn of significant changes. While a divergence can sometimes predict a price reversal, it will not be present for every reversal. Therefore, traders should complement the MFI with other forms of analysis and risk control measures, rather than relying solely on one indicator.
Summary
As outlined above, the Money Flow Index (MFI) indicator can assist in clarifying certain market movements. However, it’s crucial to remember that no single indicator should be used in isolation for making decisions about your hard-earned money. You should understand forex risks before entering the forex market.