The Money Flow Index (MFI) uses price and volume and the concept of accumulation distribution to create an overbought and oversold indicator that is helpful in confirming trends in prices and warning of potential reversals in prices.
The inputs to the Money Flow indicator are given below:
- Typical Price: (High + Low + Close) / 3
- Money Flow: Typical Price x Volume
- Positive Money Flow: The Money Flow on days where the Typical Price is greater than the previous day’s Typical Price.
- Negative Money Flow: The Money Flow on days where the Typical Price is less than the previous day’s Typical Price.
- Money Ratio: Positive Money Flow / Negative Money Flow
- Money Flow Index: 100 – [100 / (1 + Money Ratio)]
The chart below of Google (GOOG) stock shows the Money Flow Index in action:
Interpreting the Money Flow Index
- Below 20 is considered oversold; a trader might look for buying opportunities at these levels.
- Above 80 is in overbought territory; a trader might look for sell signals here.
In the chart above of GOOG, the downtrend in price was confirmed by the downtrend in the Money Flow Index. Once the MFI entered the oversold area, traders might be advised to begin to reduce their short sell positions and buy to cover.
Later, the price of Google increased, and the MFI indicator confirmed that increase. This is a signal that suggests that the trend in Google still might have buying pressure and that the stock trader might want to continue holding their long position in the stock.
In additon to acting as a confirmation tool, the Money Flow Index might be used to warn of potential price reversals. Money Flow Index divergences is next.
Money Flow Index Divergences
Since the Money Flow Index uses volume in its calculation, this indicator can prove effective as a divergence indicator. The theory is as follows:
- If price is rising, and the volume on up days is greater than the volume on down days, then this is confirming of the price rise.
- Likewise, if price is falling and the volume on down days is greater than the volume on up days, then the recent downward trend in stock prices is confirmed.
- In contrast, if prices rise, yet the volume on the up days is less than the volume transacted on down days, then money is secretly pouring out of the stock; this is a bearish divergence.
- And similarly, when prices fall, but the volume on the down days is less than the volume on up days, then money is flowing back into the stock, a bullish divergence.
The chart below of Microsoft (MSFT) shows the effectiveness of the Money Flow Index in detecting bullish and bearish divergences:
In the chart above, beginning on the left, Microsoft’s stock price is in a downtrend; however, the Money Flow Index is not going downwards, in fact, it is sloping upwards. This is a good illustration of a bullish divergence.
On the second half of the chart, Microsoft is making new highs, yet the Money Flow Index is making lower highs, a bearish divergence. Stock traders of MSFT might be advised to scale out of their position because money is flowing out of Microsoft stock.
Later, the price of Google increased, and the MFI indicator confirmed that increase. This might be interpreted that the trend in Google still has buying pressure and that the stock trader might consider continuing to hold their long position in the stock.
The Money Flow Index is an interesting technical analysis tool due to its ability to incorporate both price and volume into its calculations.
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