Watch our video on the money flow index.
What Is the Money Flow Index?
- The Money Flow Index or MFI is an indicator that shows overbought and oversold areas. That sounds a lot like RSI doesn't it? The relative strength index also looks for overbought and oversold areas. The MFI is also known as volume-weighted RSI.
The Money Flow Index is another technical analysis tool used in stock market trading. The market is a battle of the bulls and the bears. Technical tools are used to help manage risk.
As traders we're always looking for ways to get a leg up on other traders. Why? We want to be the ones to profit on a trade. In order to profit we need tools like technical analysis to look for buy and sell signals as well as support and resistance.
The stock market is a battle of buyers and sellers. That causes price to fluctuate. Technical analysis tools show us potential moves of a correction.
Stock Charts defines MFI as an oscillator that uses both price and volume to measure buying and selling pressure. RSI only looks at price to show if a stock is oversold or overbought.
The two indicators are similar. As a result, the Money Flow Index is also known as the volume-weighted RSI. The Money Flow Index provides some of the most predictive and powerful signals when a divergence occurs.
What is a divergence? It's when an oscillator is moving in the opposite direction of a stock's price. In other words, if the MFI is moving down while a stock is moving up, it's a strong signal the stock is potentially going to move in a bearish direction.
However, it's important to realize that these indicators aren't always 100% accurate. There are many things that affect the price of a stock such as news, earnings and market makers.
Hence, when seeing a divergence, look at the patterns, candlesticks and other technical indicators to get confirmation. Never trade using just one technical indicator as they are lagging indicators. What does lagging indicator mean? It's confirming the move that already happened.
In other words, indicators can't predict moves. Only confirm them. As a result, you need to manage risk.
2. Breaking Down the MFI
Gene Quong and Avrum Soudack are the creators of the Money Flow Index. Like with most technical indicators, they used a 14-day time period to calculate the MFI.
If you're big into math or spreadsheets, you can use a spreadsheet to calculate the Money Flow Index. For the rest of us, it's already calculated for us in our stock trading software.
How Do You Calculate Money Flow Index MFI?
- Here's how you calculate Money Flow Index MFI:
- The first calculations are the averages of the high, low and closing prices of a 14-day period.
- Also known as the so-called typical price.
- Next the high, low and closing prices are added together then divided by 3.
- That sum is multiplied by the day's trading volume.
- The typical price needs analyzed over time.
- You need to see which direction it heads.
- The money flow is positive when the typical price is rising for consecutive trading days.
- If the typical price is falling on consecutive trading days, then the money is negative.
- The money ratio is a running tally of moves kept for a total of 14 days.
- The Money Flow Index is calculated by taking 100 - 100/ (1 + the money ratio).
Luckily for us, this is all done in our trading software and we can just add the study to our charts.
1. Why Volume Sets It Apart From Other Indicators
Volume is a crucial part of trading. When there isn't any volume, price isn't moving. Have you ever been in a trade that moves so slow it feels like watching paint dry? This is probably a result of low volume.
Traders tend to avoid stocks that don't have volume and wait until volume comes in to start trading. Hence why incorporating volume into oscillators can be very helpful.
Since the Money Flow Index does incorporate volume into its calculations, it can sometimes give earlier signals than the RSI does. It also tends not to give false signals like other oscillators can.
As a result, wait for a divergence conformation to avoid getting in a trap. Take our day trading course to learn more about the importance of volume.
2. Overbought / Oversold With Money Flow Index
The Money Flow Index finds overbought and oversold levels through price and volume. Why is knowing when a stock is in overbought or oversold areas important to trading?
Overbought and oversold areas warn traders about unstable price levels. That's when reversals happen. It may not happen right then and there, but it is going to happen (watch us do trading live each day in our trading rooms).
The Money Flow Index gets into overbought territory when it reaches 80 and oversold when it reaches 20. Many times, stocks trade between those levels and correct before reaching the extreme levels.
Use overbought and oversold areas to confirm the strength of a trend. There are times when a stock is trading within those levels that a reversal doesn't immediately happen. That's because the trend is strong. Remember, the trend is your friend.
However, it's important to be very aware when a stock is within those Money Flow Index extreme levels because of the instability. As a result, you can play either side. What goes up must come down, especially with low float stocks.
Practice Money Flow Index
There is such a thing as too many indicators. As a result, practice trading with the money flow index coupled with other indicators. See which indicators work together so you're not receiving conflicting reports.
Learning stock market trading is going to teach you to trade properly. Putting it into practice, however, makes you a good trader. These tools don't work unless you know support and resistance as well as candlesticks and patterns.
Open a paper trading account. You'll hear us talk about placing hundreds of practice trades before going live. It's important because you learn how to use indicators and patterns.