What is the Money Flow Index Indicator?
The money flow index (MFI) is a technical oscillator that measures the inflow and outflow of money into an asset over a period of time. It looks at both price and volume to assess the buying and selling pressures in a given market.
Analysts found that volume alone was not a clear gauge of momentum – what traders should really be interested in is the market response to price changes. This is why the MFI also looks at price movement to confirm whether there is a stronger momentum upwards or downwards, indicating the sentiment of the market.
How does the money flow index work?
The money flow index works by oscillating on a scale from zero to 100. The figure presented at the end of the MFI calculation will be plotted on this scale to provide overbought and oversold signals. If the MFI reading is above 80, the market would be considered overbought, while a reading of 20 or below is a signal for oversold conditions.
The basic range is 20 to 80, So a 20% abnormality. Normally, if the MFI exceeds 80, the line will show as red, and if it falls below 20, it will appear green.
The Money Flow Index requires a series of calculations.
- First, the period’s Typical Price is calculated.
Typical Price = (High + Low + Close)/3
- Next, Money Flow (not the Money Flow Index) is calculated by multiplying the period’s Typical Price by the volume.
Money Flow = Typical Price * Volume
- If today’s Typical Price is greater than yesterday’s Typical Price, it is considered Positive Money Flow. If today’s price is less, it is considered Negative Money Flow.
- Positive Money Flow is the sum of the Positive Money over the specified number of periods.
Negative Money Flow is the sum of the Negative Money over the specified number of periods.
- The Money Ratio is then calculated by dividing the Positive Money Flow by the Negative Money Flow.
Money Ratio = Positive Money Flow / Negative Money Flow
- Finally, the Money Flow Index is calculated using the Money Ratio.
The theory behind the MFI indicator is that when these levels are met, the market price could soon reverse, and traders should think about opening a position to take advantage of the momentum.
It is also important to keep an eye out for points where the price of an asset and the money flow index are giving contradictory signals – this is known as a divergence. For example, if the price is making new highs, but the MFI doesn’t reach corresponding new levels, this would be a bearish divergence. It indicates there may soon be a selling pressure. However, if the price falls to new lows, but the MFI doesn’t follow that movement, it may be an indicator of a bullish divergence and an impending buying pressure.
It’s worth remembering that a divergence does not always result in a reversal. The MFI can produce false signals – these occur when the indicator presents a good trading opportunity, but the market price does not move as expected. This can result in unexpected losses if a trader hasn’t implemented a suitable risk management strategy.
From: IG – “How does the MFI work“