Investing & Trading

Money Flow Index Study

By Samantha Baltodano


TL;DR:

The Money Flow Index study assesses the money flowing into and out of a security to determine market trends and potential reversals. It does this by utilizing calculations found previously in the Money Flow study and the Typical Price study. 


If the MFI value is over 80, this signals a security is overbought. If the MFI value is below 20 this signals a security is oversold. It is also capable of spotting divergences which can warn of a trend reversal.


What Is the Money Flow Index Study?

As its name suggests, the Money Flow Index (MFI) is a technical oscillator that measures money flowing into and out of a security for a specified period of time. It uses price and volume data to identify overbought and oversold signals. It can also be used to spot divergences which warn of a trend change in price. 


Because it is an oscillator it is measured on a 0-100 scale. Unlike conventional oscillators such as the Relative Strength Index (RSI), the Money Flow Index incorporates both price and volume data, whereas the RSI only considers price. For this reason, some analysts call MFI the volume-weighted RSI.


The MFI is calculated as a ratio between the total Money Flow over periods having the Typical Price raised, and the total Money Flow over all periods.


Let’s dive further into the calculations!


Calculation


The Money Flow Index requires a series of calculations.


  • First, the period's Typical Price is calculated:
  • Typical Price = (High + Low + Close)/3
  • Next, Money Flow (not the Money Flow Index) is calculated by multiplying the period's Typical Price by the volume:
  • Money Flow = Typical Price * Volume
  • If today's Typical Price is greater than yesterday's Typical Price, it is considered Positive Money Flow. If today's price is less, it is considered Negative Money Flow.
  • Positive Money Flow is the sum of the Positive Money over the specified number of periods.
  • Negative Money Flow is the sum of the Negative Money over the specified number of periods.
  • The Money Ratio is then calculated by dividing the Positive Money Flow by the Negative Money Flow:
  • Money Ratio = Positive Money Flow / Negative Money Flow
  • Finally, the Money Flow Index is calculated using the Money Ratio.


What Does the Money Flow Index Tell You?


One of the primary ways to use the Money Flow Index is when there is a divergence. A divergence is when the oscillator is moving in the opposite direction of price. This is a signal of a potential reversal in the current price trend.


For example, a very high Money Flow Index that begins to fall below a value of 80 while the underlying security continues to climb is a price reversal signal to the downside. Conversely, a very low MFI reading that climbs above a reading of 20 while the underlying security continues to sell off is a price reversal signal to the upside.


Traders also watch for larger divergences using multiple waves in the price and MFI. For example, a stock peaks at $10, pulls back to $8, and then rallies to $12. The price has made two successive highs, at $10 and $12. If MFI makes a lower higher when the price reaches $12, the indicator is not confirming the new high. This could foreshadow a decline in price.


Source: Fidelity
Figure 1: Overbought/Oversold Signals + Points of Divergence


Overbought/Oversold Signals


A stock is considered overbought if the MFI indicator reaches 80 and above (a bearish reading). 


A bullish reading of 20 and below suggests that the stock is oversold.


The overbought and oversold levels are also used to signal possible trading opportunities. Moves below 10 and above 90 are rare. Traders watch for the MFI to move back above 10 to signal a long trade, and to drop below 90 to signal a short trade.


Other moves out of overbought or oversold territory can also be useful. For example, when an asset is in an uptrend, a drop below 20 (or even 30) and then a rally back above it could indicate a pullback is over and the price uptrend is resuming. The same goes for a downtrend. A short-term rally could push the MFI up to 70 or 80, but when it drops back below that could be the time to enter a short trade in preparation for another drop.


These levels may change depending on market conditions. 


Limitations


Oversold/Overbought levels are generally not reason enough to buy/sell; and traders should consider additional technical analysis or research to confirm the security's turning point. Keep in mind, during strong trends, the MFI may remain overbought or oversold for extended periods.


The MFI is capable of producing false signals. This is when the indicator does something that indicates a good trading opportunity is present, but then the price doesn't move as expected resulting in a losing trade. A divergence may not result in a price reversal, for instance.


The indicator may also fail to warn of something important. For example, while a divergence may result in a price reversing some of the time, divergence won't be present for all price reversals. Because of this, it is recommended that traders use other forms of analysis and risk control and not rely exclusively on one indicator.


Summary

  • The Money Flow Index (MFI) is a technical indicator that generates overbought or oversold signals using both prices and volume data.
  • An MFI reading above 80 is considered overbought and an MFI reading below 20 is considered oversold, although levels of 90 and 10 are also used as thresholds.
  • A divergence between the indicator and price is noteworthy. For example, if the indicator is rising while the price is falling or flat, the price could start rising.

Money Flow Index is just one of many studies that Archaide automates. For a full list of strategies and studies available click here.


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