What is the money flow index (MFI)?
The Money Flow Index (MFI) is a technical oscillator that uses price and volume data to identify overbought or oversold signals on an asset. It can also be used to detect divergences that warn of a price trend reversal. The oscillator moves between 0 and 100.
Unlike conventional oscillators such as the Relative Strength Index (RSI), the Money Flow Index incorporates price and volume data, rather than just price. For this reason, some analysts call MFI the volume-weighted RSI.
- The Money Flow Index (MFI) is a technical indicator that generates overbought or oversold signals using both price 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.
- It is worth noting a divergence between the indicator and the price. For example, if the indicator is rising while the price is falling or is flat, the price could start to rise.
The formulas for the money flow rate are:
Money flow index=1–1+Money flow ratio1where:Money flow ratio=14 Period Negative cash flow14 Positive cash flow periodGross money flow=Typical Price * VolumeTypical price=3High + Low + Close
When the price moves from one period to the next, the gross money flow is positive and adds to the positive money flow. When the gross money flow is negative because the price fell that period, it is added to the negative money flow.
How to calculate the money flow rate
There are several steps in calculating the money flow rate. If you do it by hand, it is recommended to use a spreadsheet.
- Calculate the typical price for each of the last 14 periods.
- For each period, check whether the typical price was higher or lower than the previous period. This will tell you if the gross money flow is positive or negative.
- Calculate the gross money flow by multiplying the typical price by the volume for that period. Use negative or positive numbers depending on whether the period was up or down (see the previous step).
- Calculate the money flow index by adding all the positive money flows for the last 14 periods and dividing it by the negative money flows for the last 14 periods.
- Calculate the Money Flow Index (MFI) using the index found in step four.
- Continue doing the calculations as each new period ends, using only the last 14 periods of data.
What does the money flow rate tell you?
One of the main ways to use the Money Flow Index is when there is a divergence. A divergence is when the oscillator moves in the opposite direction to price. This is a sign of a possible reversal of the prevailing price trend.
For example, a very high money flow index that begins to fall below a reading of 80 while the underlying security continues to rise is a sign of a price reversal to the downside. In contrast, a very low MFI reading that rises above a reading of 20 while the underlying security continues to sell is a sign of a price reversal to the upside.
Traders also observe larger divergences using multiple waves in price and MFI. For example, a stock reaches a high of $ 10, falls back to $ 8, and then rises to $ 12. The price has reached two successive highs, at $ 10 and $ 12. If MFI makes a lower lower when the price reaches the $ 12, the indicator is not confirming the new high. This could herald a drop in price.
Overbought and oversold levels are also used to signal potential trading opportunities. Movements below 10 and above 90 are rare. Traders are on the lookout for the MFI to fall back above 10 to indicate a long trade and fall below 90 to indicate a short trade.
Other moves outside of overbought or oversold territory may also be helpful. For example, when an asset is in an uptrend, a dip below 20 (or even 30) and then a rally above it could indicate that a pullback has ended and the price uptrend is resuming. The same goes for a downtrend. A short-term rally could push the MFI down to 70 or 80, but when it falls back below that might be time to enter a short trade in preparation for another dip.
The difference between the money flow index and the relative strength index (RSI)
MFI and RSI are closely related. The main difference is that MFI incorporates volume, while RSI does not. Proponents of volume analysis believe that it is a leading indicator. Hence, they also believe that MFI will provide signals and warn of potential reversals in a more timely manner than RSI. One indicator is not better than the other, they are simply incorporating different elements and therefore will provide signals at different times.
Limitations of the money flow index
The MFI is capable of producing false signals. This is when the indicator does something that indicates that there is a good trade opportunity, but then the price does not move as expected, resulting in a losing trade. A divergence may not result in a price reversal, for example.
The indicator may also fail to warn about something important. For example, while a divergence may result in a price reversing sometimes, the divergence will not be present for all price reversals. Because of this, it is recommended that traders use other forms of risk analysis and control and not rely solely on one indicator.