The Money Flow Index (MFI) is a technical indicator similar to the Relative Strength Index (RSI) and is known as the volume-weighted RSI. It measures trading pressure by taking into account the price, inflow and outflow of money into a financial security. The MFI is a momentum oscillator created by Gene Quong and Avrum Soudack, which is often used to identify possible reversal points in the market using volume in its calculation.
Just like the RSI, the value of the MFI ranges between 0 and 100, and uses a default setting of 14 periods for its calculation. The Money Flow Index has a high correlation with the RSI, but still differs to some extent as it takes into account the trading volume of the security. The ranging nature of the MFI makes it extremely helpful to trade market conditions that approach extreme positive or negative MFI levels.
The calculation of the MFI requires a few steps:
- Calculate the typical price: (high + low + close) / 3
- Calculate the raw money flow: typical price x volume
- Calculate the money flow ratio: (14-period positive money flow) / (14-period negative money flow)
- Calculate the MFI: 100 – 100 / (1 + money flow ratio)
Note: The positive money flow sums up all of the money flow for days which have a higher typical price than the previous period typical price. The negative money flow is calculated by summing up all of the money flow for days which have a lower typical price than the previous period typical price.
Let’s take a 3-day example on how the MFI is calculated. The same applies for any number periods as well.
Day 1: high = $5.9, low = $5.2, close = $5.3, volume = 10,000
Day 2: high = $5.5, low = $5.0, close = $5.4, volume = 8,000
Day 3: high = $6.2, low = $5.4, close = $5.9, volume = 12,000
Step 1: The typical prices are calculated based on the high, low and close price each day
Day 1: ($5.9 + $5.2 + $5.3) / 3 = $5.47
Day 2: ($5.5 + $5.0 + $5.4) / 3 = $5.3
Day 3: ($6.2 + $5.4 + $5.3) / 3 = $5.63
Step 2: The raw money flow is calculated by multiplying the typical price by volume
Day 1: $5.47 x 10,000 = 54,700
Day 2: $5.3 x 8,000 = 42,400
Day 3: $5.63 x 12,000 = 67,560
Step 3: Calculation of positive and negative money flows
Positive money flows = 67,560
Negative money flows = 42,400
Step 4: Calculation of the Money Flow Ratio
Money flow ratio =67,560 / 42,400 = 1.59
Step 5: Calculation of the Money Flow Index
MFI = 100 – 100 / (1 + 1.59) = 100 – 38.61 = 61.39
Trading Overbought and Oversold Conditions with the MFI
The MFI can be used to identify overbought and oversold market conditions. A value of over 80 suggests an overbought condition, while a value below 20 suggests an oversold condition. However, a major problem with trading overbought and oversold conditions is that the price of a security may continue its rise or fall although the MFI is above 80, or below 20.
To overcome this problem, traders can also wait for the MFI to break above 90 or below 10 for extreme overbought and oversold conditions. Securities rarely push the MFI to such extreme levels, but once they do, it suggests unsustainable price levels and price is very likely to reverse.
Overbought and oversold levels should not be used to open short or long positions in itself, but should be accompanied by a confirming signal such as candlestick patterns or trendline breakouts.
Trading Divergences with the MFI
Furthermore, the MFI is also used to trade bearish and bullish divergences between the price and the oscillator and failure swings at the 80 and 20 levels, which often signal a trend reversal.
A bullish divergence forms when the price makes a lower low, but the indicator makes a higher low which means that bullish momentum is catching up. On the other hand, a bearish divergence forms when the price makes a higher high, but the indicator makes a lower high, signaling that bearish momentum is increasing.
A bullish failure swing forms when the MFI enters the oversold territory below 20, moves back above 20, holds above 20 on a pullback and manages to form a new higher high. On the other hand, a bearish failure swing forms when the MFI enters the overbought territory above 80, moves back below 80, holds below 80 on a pullback and forms a new lower low.
Combine MFI with Other Indicators
The Money Flow Index is a momentum indicator that combines volume and prices to measure the buying and selling pressure for a security. It’s also known as the volume-weighted RSI, as it takes the volume into consideration but uses a formula similar to the RSI for its calculation. The MFI gives the best results when used to identify potential reversal zones.
Generally, a reading above 80 signals overbought market conditions, while a reading below 20 signals oversold market conditions. Traders can also use more strict levels, such as 90 for overbought conditions and 10 for oversold conditions, although the indicator rarely reaches such extreme levels.
Just like any other momentum indicator, the MFI should be used in combination with other confirming signals, such as with candlestick patterns, chart patterns, trendlines and channels.