Money Flow Index: In the fast-paced world of financial markets, understanding and utilizing reliable indicators is key to making informed trading decisions. 

Among all technical tools available, the money flow index is a volume-based oscillator, that offers valuable insights into market trends and potential reversals. In this article, we shall explore the Money Flow Index indicator with its meaning, calculation, and trading strategies with examples.

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What is a Money Flow Index(MFI)?

The money flow index is a momentum oscillator that uses price and volume data to identify the outflow and inflow of money over a specific period. The technical indicator helps traders to spot overbought/oversold zones and the divergence formed between the indicator signals price trend reversals and spot entry opportunities. 

The oscillator ranges between 0 to 100 levels, it is similar to the relative strength index(RSI) indicator, in which it considers only price data but MFI accounts for price and volume. Hence it is also known as the volume-weighted version of RSI.

Calculating the Money Flow Index(MFI)

Understanding the steps involved in calculating the MFI indicator helps to know what exactly the indicator is showing. Here are the series of steps involved in calculating the indicator.

  • Typical price is calculated for a specified period length.

Typical price = (high+low+close)/3

  • Raw money flow is the approximation of how much capital is pumped into the market in a specific period length.

Raw money flow = Typical price x Volume

  • The money flow ratio is calculated as the ratio of positive money flow to negative money flow.

The money flow is positive when the current period’s price is higher than the previous period, and vice versa for negative money flow.

  • From all the above calculations, the money flow index can now be calculated as

Money flow Index(MFI)= 100 – (100/1 + money flow ratio)

Money Flow Index Strategies to Trade

The indicator oscillates between the specified range where different strategies can be employed to analyze the potential views on price movements.

Overbought and Oversold levels

The money flow index is used to generate overbought and oversold levels. The oscillator ranges between 0 to 100. Usually, the default settings are set to 20 and 80 range in charts. When the indicator ranges between 80 to 100 it is considered as the overbought zone, and here one could look for an exit of the long position and entry to the short position of security.

The price of a security is regarded to be oversold when the indicator oscillates between 0 and 20, at this oversold zone an opportunity for a long position can be identified and a short position can be squared off as a sign of a trend reversal.

Money flow index- Overbought and Oversold levels

Here, it should be understood that an overbought level doesn’t mean bearish and an oversold level doesn’t mean bullish always. In a strong trend, the oscillator remains in the overbought or oversold zone for a certain period. So it is important to understand the direction and strength of the trend and take positions accordingly. By the trader’s methods, the overbought and oversold levels can also be altered to any level between 0 to 100.

Money Flow IndexDivergence

Money flow index divergence occurs when the price of the securities direction is opposite to the change in momentum of the MFI oscillator.

Two types of MFI Divergence

  1. Bullish Divergence
  2. Bearish Divergence 

Bullish Divergence.

When the price of a security is forming a lower low but the MFI indicator is diverging by making higher lows, a bullish divergence is formed. This suggests a strengthening bullish momentum, and once it moves above the oversold level as a confirmative trade, a long position can be opened.

Money flow index - Bullish Divergence

Bearish Divergence.

A bearish divergence is formed when the price of a security records a higher high but the MFI indicator forms lower highs. Here the weaker momentum formed in the MFI gives the signal to take a short position or exit the long position. It is advised to take a confirmed trade once the MFI indicator moves below the overbought zone.

Bearish Divergence

Money Flow Index Vs Relative Strength Index (RSI)

RSI is the momentum-based technical indicator that helps traders spot trend reversals by spotting overbought and oversold zones.

  • The MFI and RSI are closely related in depicting overbought and oversold zones.
  • The main difference is that MFI accounts for volume and price data, while the RSI only depends on price data.
  • Similar to RSI, the value of MFI also ranges between 0 to 100. Still, the oscillation path of the indicator differs to some extent as MFI considers the trading volume of the security to count.
  • MFI provides lead signals of possible reversals in more timely than RSI due to consideration of volume.

Limitations of the Money Flow Index

  • The indicator can generate false signals which can lead to unexpected losses in certain market conditions.
  • Overbought and oversold zones don’t result in an end of the trend, further trend continuation can also be seen.
  • Can’t rely only on the money flow index indicator as some signals can be missed to spot potential profits.

Conclusion

Having understood the working and application of the money flow index indicator, it is important to practice analyzing the signals generated to spot confirmed entry and exit opportunities. Traders can combine other strategies with the indicator for valid confirmed signals, before employing the strategies it is important to backtest and understand them. 

Rather than relying on one technical tool, it is always preferred that the money flow index should be used in conjunction with other technical tools for better entries with good risk-to-reward ratios.

Written By Deepak M

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