## Trading with the Money Flow Index

June 26, 2016 01:00 PM

The Money Flow Index (MFI) is a momentum indicator that measures the strength of money flowing into and out of a security. It uses both price and volume to measure buying and selling pressure. This information can then inform the trader on when to enter or exit a position in the security being analyzed.

Created by Gene Quong and Avrum Soudack, the MFI is related to the relative strength index (RSI), but where the RSI only incorporates price in its calculation, the MFI accounts for volume.

The MFI starts with the typical price for each period. Money flow is positive when the typical price rises, indicating buying pressure, and negative when the typical price declines, indicating selling pressure.
A ratio of positive and negative money flow is then plugged into an RSI formula to create an oscillator that moves between 0 and 100.

As a momentum oscillator tied to volume, the MFI is best suited to identify reversals and price extremes with a variety of signals. “Apple momentum” (below) shows Apple (AAPL) stock along with the MFI indicator.

### Calculation

The MFI requires a series of calculations. First, the period’s typical price is calculated. This is the average of the high, low and close:

Typical Price = (High + Low + Close)/3

Next, raw money flow (not the MFI) is calculated by multiplying the period’s typical price by the volume:

Raw Money Flow =  Typical Price x Volume

If the day’s typical price is greater than the previous day’s typical price, then money flow is considered positive. Positive money flow is the sum of the positive money over the specified number of periods. If the current day’s price is less than the previous day’s price, the money flow is considered negative. 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 over a specified period of time; generally, 14 is used as a default period.

Money Flow Ratio = (14-period Positive Money Flow) / (14-period Negative Money Flow)

Finally, the MFI is calculated using the money ratio:

Money Flow Index = 100 - 100 / (1 + Money Flow Ratio)

### Interpretation

The MFI’s calculation generates a value that is then plotted as a line that moves within a range of 0 to 100, making it an oscillator. When the MFI rises, this indicates an increase in buying pressure. When it falls, this indicates an increase in selling pressure. The MFI can generate several signals, most notably overbought and oversold conditions and divergences (positive and negative).

The interpretation of the MFI is as follows:

• Overbought/oversold readings: Look for market tops to occur when the MFI is above 90. Look for market bottoms to occur when the MFI is below 10.
• Divergence between the indicator and price action: If the price trends higher and the MFI trends lower (or vice versa), a reversal may be imminent.

### Overbought/oversold

Overbought and oversold levels can be used to identify unsustainable price extremes. An MFI reading above 90 is considered overbought, while an MFI below 10 is considered oversold.

Be wary of trading these levels blindly. As the warning goes, an overbought market can remain overbought for an extended period. Strong trends can present a problem for these classic overbought and oversold levels. The MFI can become overbought, and prices can simply continue higher when the uptrend is strong. Conversely, the MFI can become oversold, and prices can simply continue lower when the downtrend persists. The same goes for oversold markets. Like the RSI, this indicator is best used in conjunction with another indicator as confirmation.

Originally, the levels 80 and 20 were used for overbought and oversold readings. Quong and Soudack recommended expanding these extremes to further qualify signals. A move above 90 is considered truly overbought and a move below 10 is considered truly oversold. Moves above 90 and below 10 are rare occurrences that suggest a price move is unsustainable.

For example, in “Too high, too long” (below), IBM is shown to have been in a strong uptrend from Feb. 11, 2016, where it made a low of \$116.90 and has been rallying to a high of \$153.50 on Apr. 4. On Apr. 1, the MFI touched 91.7. This level is considered not sustainable, and if we get a confirmation from a reversal candlestick, it makes a case for short selling.

On April 4, IBM made a gravestone doji candlestick, which is a reversal pattern. This confirms that shorts could be taken around \$152 with a stop loss of \$154, for a 5% to 6% down move, or until the MFI reaches 50, at which point a partial profit taking trade could be done with the remaining position being carried forward with a trailing stop. As of Apr 11, IBM had made a low of \$147, almost 3.5% down from the short trigger level of \$152.

An oversold reading works the same way, just on the other end of the extreme. Alcoa Inc. (AA) had been in a strong downtrend from Dec. 29, 2015, when it made a high of \$10.23. By Jan. 20, 2016,
it reached a low of \$6.11. As shown on “AA rebound” (below), on Jan. 20 the MFI reached a scant 0.92. This level is not sustainable, and if we get a confirmation from a reversal candlestick pattern, it makes a case for going long AA.

We got our signal that very day as AA formed a hammer candlestick pattern. Longs could have been taken around \$6.60 with a stop loss at \$6 for a 5% to 6% move or until MFI reaches 50, at which point partial profits can be taken. AA made a high of \$8.45 on Feb. 4, 2016, when the MFI reached 50.

### Divergences

MFI divergence describes the scenario where price action and the MFI indicator provide different signals. This difference in signal can be interpreted as an impending reversal in price. Divergences can be both bearish and bullish.

A bullish MFI divergence is where the indicator drops below 20 and then surges above 20, holding that level and then breaking higher than the prior reaction high. The divergence comes when the price action makes a lower low while the indicator performs this recovery action.

A bearish MFI divergence is simply when price and the indicator react in an opposite manner: Price makes a new high, but the MFI makes a new low.

On the Valeant Pharmaceuticals International Inc. (VRX) chart (see “Mixed signals,” below), a bullish divergence can be seen when price makes lower lows in October to November 2015, but the MFI makes higher highs. Subsequently, the stock’s price rallied from a low of \$69 on Nov. 18 to \$119 until the MFI became slightly overbought, touching the \$80 level.

The MFI is a rather unique indicator that combines momentum and volume with an RSI formula. Because of its incorporation of volume, the MFI is better suited to identify potential reversals using both overbought/oversold levels and bullish/bearish divergences. As with all indicators, the MFI should not be used by itself. A pure momentum oscillator, such as RSI, or pattern analysis can be combined with the MFI to increase signal accuracy.