The Money Flow Index is another technical analysis tool used in stock market trading. Stock Charts defines MFI as an oscillator that uses 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.
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What Is the Money Flow Index (MFI)?
The Money Flow Index, or MFI, is an indicator that shows overbought and oversold areas. That sounds a lot like RSI. The relative strength index also looks for overbought and oversold areas. The MFI is also known as volume-weighted RSI.
The market is a battle of the bulls and the bears. Technical tools are used to help manage risk.
As traders, we always look for ways to get a leg up on other traders. Why? We want to be the ones to profit from a trade. To profit, we need tools like technical analysis to look for buy and sell signals and support and resistance.
The stock market is a battle of buyers and sellers. That causes the price to fluctuate. Technical analysis tools show us potential moves of a correction.
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Divergence
What is a divergence? It’s when an oscillator moves opposite to a stock’s price. In other words, if the MFI is moving down while a stock is moving up, it’s a strong signal that it will potentially move in a bearish direction.
However, it’s important to realize that these indicators aren’t always 100% accurate. Many things 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 the 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.
Money Flow Index (MFI) Breakdown
Gene Quong and Avrum Soudack are the creators of the Money Flow Index. Like with most technical indicators, they used 14 days to calculate the MFI.
You can use a spreadsheet to calculate the Money Flow Index if you’re big into math or spreadsheets. For the rest of us, it’s already calculated for us in our stock trading software.
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How Do You Calculate Money Flow Index MFI?
- Here’s how you calculate the Money Flow Index MFI:
- The first calculations are the averages of the high, low, and closing prices of 14 days.
- It is also known as the so-called typical price.
- Next, the high, low, and closing prices are added together and divided by 3.
- That sum is multiplied by the day’s trading volume.
- The typical price needs to be analyzed over time.
- You need to see which direction it heads.
- The money flow is positive when the typical price rises for consecutive trading days.
- The money is negative if the typical price falls on consecutive trading days.
- The money ratio is a running tally of moves kept for 14 days.
- The Money Flow Index is calculated using 100 – 100/ (1 + the money ratio).
Luckily, this is all done in our trading software, and we can add the study to our charts.
Why Volume Sets It Apart
Volume is a crucial part of trading. When there isn’t any volume, the price isn’t moving. Have you ever been in a trade that moves so slowly 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, incorporating volume into oscillators can be very helpful. Since the Money Flow Index incorporates volume into its calculations, it can sometimes give earlier signals than the RSI. It also tends not to give false signals like other oscillators can.
Trading services can pump up a stock, which sends volume surges. They do this through trading rooms or trading apps such as StockTwits.
As a result, wait for a divergence confirmation to avoid getting in a trap. Take our day trading course to learn more about the importance of volume.
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Overbought / Oversold
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 will happen.
The Money Flow Index gets overbought territory when it reaches 80 and oversold when it reaches 20. Often, 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 extreme Money Flow Index levels because of the instability. As a result, you can play either side. What goes up must come down, especially with low-float stocks.
Final Thoughts: 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.
