The law of supply and demand is a theory that explains the direct relationship between the availability of a product and its price. A product that is high in demand tends to have an increased price, while a lower demand could drop the product’s price.
Even with all its complexities, the same law is the basis for determining a stock price. A company’s share experiencing higher buying pressure will pump up a share’s price, while a selling pressure will do the opposite.
The best way to go about trading in stock markets is often predicting a buying pressure or a selling pressure, otherwise known as trends. Foreseeing a trend or trend reversal can help you make use of the same to make a profit.
A money flow index (MFI) is a technical analysis indicator that could help you identify these trends. Let us learn more about the money flow index and see how you can employ MFI trading strategies in intraday trading.
Positive money flow vs Negative money flow
One of the crucial indicators that shows the demand a stock has is money flow into and outside of that security. Positive and negative money flow has different implications. Accelerated money flow into a stock means more investors are buying the stock, while a negative money flow could mean more investors are trying to sell.
What is the Money Flow Index (MFI) Indicator?
A money flow index is a technical momentum indicator that analyses the flow of money to and from a stock over a specific period of time. This data can determine whether there is a buying or selling pressure for a stock.
Created by Gene Quong and Avrum Soudack, MFI belongs to the category of oscillators – a technical indicator where the value oscillates between the set of high and low levels.
In the case of the money flow index, the values range between 0 and 100, where a lower level represents selling pressure, and a higher level represents buying pressure. Take a look at the chart below.
Here, the below portion is what an MFI graph would look like. In this case, you can see the MFI value of 80 at the end time of the market close.
Let us take an example to understand this better.
Let us assume the stocks price for the day as below
Today’s high: Rs.50
Today’s close: Rs.47
Today’s low: Rs.45
Volume: 100,000 shares
Hence, Typical Price = (50 + 47+45) / 3 = Rs. 47.3
Money Flow = Rs.47.3 * 100,000 = Rs.4,730,000
Similarly,
Yesterday’s high: Rs.52
Yesterday’s close: Rs.49
Yesterday’s low: Rs. 46
Volume: 95,000 shares
Thus:
Typical Price = (52 + 49 + 46) / 3 = Rs.49
Money Flow = 49 * 95,000 = Rs.4,655,000
Here, you can see that today’s typical price was lower than yesterday’s. Hence, the money flow index shows a negative today.
MFI vs RSI
The primary use of a money flow index is to evaluate a particular stock’s overbought and oversold levels. The relative strength index (RSI) is a similar indicator that does the same function, and many traders get confused between the two as well.
RSI is also a momentum indicator that analyses price changes over a period to determine. But the main difference between these two is that the volume of trades is also considered when we calculate the money flow index. In fact, MFI is called a volume-weighted RSI. But how does that help? Let us take a look.
How Does Integrating Volume Help?
Including volume in any momentum, oscillator calculation improves the perspective. Without volume being a factor, an indicator could show you misrepresented data due to a few odd trades.
For example, an indicator like RSI could show you less information-backed data when there are one or two more significant trades. Here, the fact that only two trades have happened is not considered for calculation; instead, the magnitude of the trade is solely considered.
But an indicator like the money flow index will also consider volume data. This will result in a more moderate and steady graph, which is more informative for the trader. When a trader is more informed, they are able to make better trade decisions.
How to calculate the money flow index?
As said above, the money flow index is represented in a value between 0 and 100. Using the index to analyze your trades is easy these days as most charts allow you to simply add the money flow index study method into your current price chart.
But knowing how to calculate the money flow index is necessary for understanding its implications. All stock market indicators have more than just surface-level information to tell you. The same is the case with the money flow index. Understanding the MFI calculation will allow you to use the index’s data better.
Finding the typical price is the first step in money flow index calculation. Let us see how that is done.
Finding typical price
Simply put, a typical price is an average value of a stock on a given day. An increase in typical price denotes a positive money flow, while a decrease in typical price shows a negative money flow.
You can use the below equation to find the typical price –
Typical Price = (Lowest price + Highest price + Closing) / 3.
Finding the raw money flow
The next step is to find the raw money flow. Here is where volume is included in the calculation. Below is the equation for that –
Raw Money Flow = Volume x Typical Price
Finding Money flow ratio
Next, we need to calculate the money flow ratio. This can be calculated by adding all the positive money flow over the last 14 days and dividing it by the last 14 days of negative money flows.
In the form of the equation, it is –
Money Flow Ratio = 14-period Positive Money Flow / 14-period Negative Money Flow
Calculating MFI
We now have all the necessary data to calculate the money flow index. The formula for the same is –
Money Flow Index (MFI) = 100 – [100 / (1 + Money Ratio)]
This calculation will show a value between 0 and 100, representing the overbought and oversold conditions.
Now, what is considered overbought and oversold is subjective, and it depends on the particular stock and the market situation.
But as a rule of thumb, a stock’s graph with an MFI value of more than 80 is considered to have high buying pressure. On the other hand, MFI values less than 20 show oversold signals. But what this means and when to take action on this data depends on many other factors as well.
Difference Between MFI & Chaikin MFI index
The Chaikin Money flow index is another similar index used to calculate money flow. But their similarities end there. The Chaikin money flow index calculates and gauges the trends in a different way. Here, Chainkin uses two moving averages.
Here MFI is different from Chainkin primarily because it uses volume along with the price data to come to a conclusion. Since these two are calculated differently, the trade signals from both tend to be different as well.
4 Easy Trading Strategy using MFI Indicator
Now that we have seen how to calculate the money flow index let us put it to the test. As discussed above, MFI is primarily used to identify overbought and oversold signals. Let us examine this using the help of a price chart.
Overbought signals
Take a look at ONGC’s price chart above. Here, the above graph shows the price action, while the below graph represents the money flow index. Pay attention to the part of the chart represented by the arrow where the money flow index nears 80, representing an overbought condition. There could be more than one takeaway from this data, but here, you can clearly see the stock price correcting right away after being oversold.
How you use this data can vary. For example, you can see that the MFI indicator is slowly rising before it reaches its peak. It could have been a sign of buying pressure, and you could buy then to pocket some profit. Similarly, shortly after, the peak and the slight descent is a sign of correction and was a good sell signal.
Oversold signals
Above is a price chart of TCS. Take a look at the point where the MFI indicator reached a low point near 20. This indicates selling pressure. As a response, you can see the price rising right after as a corrective reaction.
There can be different interpretations in the case of oversold signals too. Unlike in the above example, MFI dropping could also indicate a price drop without a correction for a long time. In those scenarios, it can be a sell signal. Here, the best course of action is to refer to other momentum indicators as well before making a choice.
Identifying divergence
Sometimes, the MFI data might not agree with the price and volume data. In those cases, the price might go in the opposite direction of the money flow index. Such cases are known as divergence. These usually indicate a trend reversal.
Bearish divergence
Pay attention to the above picture. Here you can see that the money flow index oscillates but favours lower levels, but the price is hitting new highs. In such a situation, usually, the price gives up after a point to show a trend reversal. Here too, you can see the price falling right after.
Spotting a bearish divergence can help you sell your stocks to minimise loss or enter a short position to take advantage of the situation.
Bullish divergence
A bullish divergence is the exact opposite of a bearish divergence. In this graph, you can see that MFI favours the higher levels, but the price is falling. From the point noted by the arrow, the trend changes, and the price starts to rise.
You can use a bullish divergence scenario to predict an upward trend reversal. Traders either buy the stock or enter long positions to take advantage.
Identifying failure swings
Similar to divergence, failure swings are also considered trend reversal indicators. But failure swings are not dependent on the price action and MFI data alone. Let us look at the conditions where a bearish and bullish failure swing could occur.
Bullish swings
The part marked in the above graph is how a bullish swing would look like in a price chart. Here, the money flow index initially decreases below 20. Then, you can see a recovery, and it rises above 20. But the money flow index goes down again but without breaching the 20-level mark. After that, it shoots above to reach a more than the previous level.
As a result of the swing, an evident bullish trend is visible in the graph right after.
You can use this data to time your entry and exit during an intraday trade. For example, if you see a bullish swing forming, you could analyze the same and buy the stock to make use of the following uptrend that could happen.
Bearish swings
A bearish failure swing is the opposite of a bullish one. It usually indicates a downward trend. The above picture is how the same will appear on a price and MFI chart.
Here, the MFI has to increase above 80 first, creating an overbought scenario. After that, it has fallen below 80. The recovery that follows will end below 80. MFI will then stoop down to a level below the previous bar.
Here are some alternatives to MFI indicator: Important technical indicators
Forming MFI indicator trading strategies
The money flow index data, like any other indicator, is an excellent source of information to form trading strategies. But it is essential to always keep an eye on the overall market conditions before you make a trade by following money flow index data. This is because, during times of economic uptrends or downtrends, the price could move independently of MFI. Even during an average economic period, cross-checking with data from other indicators will help you make sure you make the right move. Blindly following the MFI data without knowledge about economic conditions or without cross-checking with another momentum indicator may end up being a wrong decision. Take a look at the below picture.
Here, pay attention to the area marked with a white rectangle. Here, you can see overbought signals, but it doesn’t reflect on the price. There is no sign of a divergence or failure swings, and hence no trend reversal as well. Situations like these are the reason why you should always cross-check before making a trade based on technical analysis.
Bottomline
A money flow index is an efficient and beneficial tool to gauge overbought and oversold conditions. The above analysis about MFI will help you grasp essential information about the same and able you to employ MFI indicator trading strategies on your own. Make sure you do your research about a share before employing any technical indicator to ensure the best results.
FAQs
Which is better RSI or MFI?
Both RSI and MFI are used by traders for similar functions but the main difference here is that MFI is volume-weighted. This means MFI could be carrying more information than RSI. Having said that, both indicators are popular and proven and how you use it can define you success using it.
Is MFI a leading indicator?
Yes, MFI is one of the most used technical analysis tools out there. It is used both as a momentum finding tool and a trend confirming tool.
Is MFI good for day trading?
MFI is a beneficial indicator for day trading as well. Although similar to other indicators, it could show false signals as well. Hence, make sure you always confirm the trend and keep an eye on what is happening in the economy while using it.
