The Money Flow Index (MFI) is an indicator that utilises volume and price to determine the selling and buying pressure on a financial instrument. In simple terms, it measures the outflow and inflow of money into a particular asset over a specific period.
Analysts believe that trading volume alone is not a clear and precise momentum gauge in an asset. This is why MFI focuses on price movements to determine whether the momentum toward an asset is in an upward or downward direction. This signifies the market sentiments about the asset.
Read on to know how MFI works and how it is used in trading.
The Money Flow Index indicator works by rotating on a scale of 0 – 100. The figure or result obtained by MFI calculation is plotted on a scale to provide oversold and overbought signals. An MFI index of more than 80 indicates an overbought security. Meanwhile, a result of 20 or less indicated an oversold asset on the market.
The primary theory behind this indicator is that the market price could reverse when these levels meet. As a result, traders would start opening a position to take advantage of this momentum.
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As a trader, you may not have to calculate the MFI index manually, as trading platforms do this calculation automatically. However, knowing the steps involved in this process could help you understand the results this indicator tries to show.
Mentioned below are the detailed steps to calculate the MFI index of a security:
You have to find out the average of high, low and closing prices for the last 14 periods to calculate the typical price. Here is the formula for this calculation:
Typical price = High + low + close price / 3
Raw money flow is the approximate capital passed through a market during a particular period. You can calculate this by multiplying a stock’s typical price by its trading volume.
Raw money flow = typical price x volume
Upon calculating the raw money flow for the last 14 periods, you can determine whether it’s positive or negative. You can determine this by examining whether the money flow in the current period is higher or lower than before.
That said, if its typical price in the current period is more than that of a period before, it is called positive money flow. Subsequently, a lower current typical price denotes negative money flow.
After getting the positive and negative money flows, you need to calculate the money flow ratio. You can do so by applying this formula:
Money flow ratio = positive money flow / negative money flow for the last 14 periods
The next step after getting the money flow ratio is to calculate MFI. The MFI formula is:
Money Flow Index = 100 – 100 / 1 + money flow ratioHaving said that, the Money Flow Index will be considered positive if an asset’s price has significantly risen in the last 14 periods. It will be negative if the price of an asset falls substantially over this period.
The best way to utilise the Money Flow Index indicator is to determine whether an asset is oversold or overbought. Note that an asset is overbought when the MFI goes above 80. Meanwhile, it is considered oversold when the MFI goes below 20.
As mentioned above, there is a good chance for a price reversal to happen after an asset touches the overbought or oversold levels. However, this is not necessarily true. Sometimes, the price may grow higher even after reaching an overbought level. It may also continue to drop upon reaching an MFI of 20. This typically happens due to a very robust market trend.
The Money Flow Index strategy is of extreme help when it comes to identifying potential reversals upon figuring out the oversold and overbought signals. It can help you determine market sentiments around a particular asset.
Moreover, MFI is also considered one of the leading technical indicators. So, you can use this strategy to improve your market predictions.
The Relative Strength Index (RSI) is a technical indicator that measures the speed and magnitude of price deviations of a particular security. It is displayed as a momentum oscillator with a value ranging from 0 to 100 and shows if a security is over or undervalued.
Typically, MFI features a similar interpretation as that of RSI. The primary difference between Money Flow Index and Relative Strength Index is that the former uses volume to predict market movements. Thus, MFI tends to take a different path as volume moves ahead of price.
Moreover, the default locations are another point of difference between both these indicators. The overbought default level in RSI is 70, while the oversold level is 30. In MFI, they are 80 and 20, respectively.
Since the MFI indicator strategy helps predict market sentiments, it can significantly help you during your trading journey. You can incorporate the following trading techniques with Money Flow Index to make informed decisions:
Failure swings are another instance that indicates the possibility of a price reversal. They are entirely price-independent and rely completely on MFI. This trading technique consists of four steps and shows bearish or bullish signals.
You can consider putting your money in the market when the MFI increases from its previous high, as it is generally a good signal. Even divergence of price from MFI can show bullish signals.
Typically, when the MFI goes below its previous signal, it is a good short-sell indicator. A divergence of MFI from a security’s price can also show a selling opportunity.
The Money Flow Indicator is one of the most useful momentum indicators used for technical analysis of a stock. You can incorporate this indicator in your trading journey to evaluate market sentiments or combine it with other metrics for even better predictions. However, it is important to remember that these indicators are not always accurate.
Ans. Sometimes, an asset’s price and the Money Flow Index can show contradictory results. This is called a divergence. For instance, suppose the price is reaching new highs, but the MFI remains in the same position. This would indicate a bearish divergence.
In contrast, if the price falls drastically and the MFI does not follow that, it indicates bullish divergence.
Ans. Tick volume is an indicator that measures every trade, whether up or down. It also includes the volume that comes along with those trades for a particular period. This indicator is useful as it is difficult to get real volume data on an asset in many markets.
Ans. An asset or security is considered overbought when its MFI indicates a swift price rise to higher levels. On the other hand, oversold conditions are displayed when its MFI shows a significant price decline to a considerably lower position.
Ans. The main difference between both these indicators is that MFI uses volume while RSI does not. Thus, MFI exhibits possible price reversals and lead signals in a timely manner, sometimes even ahead of RSI. This might be an added advantage of MFI.
ns. Typically, MFI takes into account extensive information while calculating the oversold and overbought levels. Thus, it is a good indicator of the financial market, which can help day traders make informed and smart investment decisions.
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
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