Monitoring the price of stocks or crypto assets on a regular basis can be highly time-consuming. During daily trading, you might need to evaluate the price movements of hundreds of different assets across multiple industries worldwide.
To help streamline this process, economists have developed various tools designed for everyday use, making market analysis more efficient and manageable. One such tool is the Money Flow Index (MFI), a popular technical indicator used by traders to gauge buying and selling pressure in a financial market.
It’s often referred to as a volume-weighted Relative Strength Index (RSI) because it incorporates both price and volume data to measure momentum. The MFI helps investors determine overbought and oversold conditions, providing insight into potential trend reversals.
This article provides a simple guide to MFI, how it works, and how traders can use it effectively.
Key Takeaways
- The Money Flow Index (MFI) measures market momentum using both price and volume data.
- MFI values above 80 indicate overbought conditions, while values below 20 suggest oversold conditions.
- Traders use the MFI to identify potential trend reversals, divergences, and confirm trends.
- It’s most effective when combined with other technical indicators to avoid false signals.
What Is the Money Flow Index?
The Money Flow Index (MFI) is a technical indicator that reflects the rate at which money is flowing into or out of a security. It uses both price and volume data to detect overbought or oversold conditions in an asset, as well as potential trend reversals through divergences.
The MFI oscillates between 0 and 100, similar to the Relative Strength Index (RSI), with the key distinction that the MFI incorporates volume into its calculations. Analysts observed that volume alone was not an accurate measure of momentum; instead, the market’s response to price changes is what truly matters.
For this reason, the MFI also takes price movement into account to confirm the strength of upward or downward momentum, reflecting broader market sentiment.
The MFI is interpreted in a manner similar to the RSI. When interpreting the Money Flow Index, the following points should be considered:
- MFI Above 80 (Overbought): A reading above 80 indicates that an asset is potentially overbought, suggesting that a price correction or pullback might occur soon.
- MFI Below 20 (Oversold): A reading below 20 indicates that an asset is potentially oversold, implying that there could be a price rebound or upward momentum soon.
- Divergences: If the MFI moves in the opposite direction of price, it could signal an impending reversal. For example, if prices are rising while the MFI is falling, this could indicate weakening buying pressure and a potential price drop.
Note that although the creators of the MFI, Gene Quong, and Avram Soudack, originally proposed using the 10 and 90 levels as thresholds for these conditions, prices seldom reach these extremes.
Key Components of MFI are:
- Price: The average price during a given period.
- Volume: The number of shares or contracts traded in the given period.
- Money Flow: The product of average price and volume for a given period.
How to Calculate Money Flow Index
The MFI is calculated using positive and negative money flows to determine whether there is more buying or selling pressure. The MFI calculation involves several steps:
1. Calculate the Typical Price (TP) for the specified time period:
TP = (HIGH + LOW + CLOSE) / 3
2. Calculate the Money Flow (MF):
MF = TP * VOLUME
If the current typical price exceeds the previous typical price, the money flow is considered positive; otherwise, it is negative. A positive money flow indicates that investors are accumulating positions in the asset, while a negative flow suggests that they are exiting their positions.
3. Calculate the Money Ratio (MR):
MR = Positive Money Flow (PMF) / Negative Money Flow (NMF)
4. Calculate the Money Flow Index (MFI):
MFI = 100 – (100 / (1 + MR))
The MFI typically uses a default time period of 14, with a fixed minimum of 0 and a fixed maximum of 100. This results in the MFI value oscillating between 0 and 100. Note that the time period can be adjusted based on trader preference.
Practical Applications of the Money Flow Index
Here’s how to use the signals generated by the MFI indicator:
Overbought and Oversold Conditions
Source: TradingView
As noted earlier, an MFI reading above 80 indicates overbought conditions. In such a situation, traders should look for opportunities to place sell orders, anticipating a potential trend reversal.
Conversely, an MFI reading below 20 signals oversold conditions. When this occurs, traders should seek opportunities to place buy orders, expecting a trend reversal.
Divergences
A divergence happens when the price moves in the opposite direction of the MFI indicator. A bullish divergence occurs when the price is declining while the indicator values are rising. This suggests that selling pressure is weakening and that buyers may soon take control.
Source: TradingView
Such a divergence can present a buying opportunity at a lower price. Conversely, a bearish divergence arises when the price is rising, but the indicator values are falling. This signals diminishing buying pressure, indicating that sellers may be gaining the upper hand.
Source: TradingView
A bearish divergence can provide an opportunity for sellers to exit at a higher price by placing short sale orders.
Failure Swings
Similar to divergences, failure swings can also lead to price reversals. However, unlike divergences, failure swings are not influenced by price movements and are solely based on the MFI. Both bullish and bearish failure swings consist of four key steps.
Bullish Money Flow Index (MFI) Failure Swing
- The MFI falls below 20, indicating an oversold condition.
- The MFI rebounds and rises above 20.
- The MFI declines again but remains above 20.
- The MFI breaks above the previous high.
Bearish Money Flow Index (MFI) Failure Swing
- The MFI rises above 80, signaling an overbought condition.
- The MFI falls below 80.
- The MFI makes a slight recovery but stays below 80.
- The MFI drops below the previous low.
Trend Pullbacks
In trending markets, the strategy is often to align with the prevailing trend during price retracements. The MFI can aid in this decision-making. During an uptrend, if the MFI drops below 20 and then rises back above, it signals the end of the retracement, indicating that prices are likely to resume their upward movement.
In a downtrend, an MFI spike above 80 followed by a drop below that level suggests that the retracement is over and that prices are ready to continue their downward trajectory.
Trading Breakouts
Source: Pinterest
When the MFI makes a sharp move out of overbought or oversold conditions, it can sometimes precede a breakout. Traders often use this in conjunction with other technical indicators to confirm their trades.
Volume Confirmation
Since the MFI incorporates volume, it can act as a volume confirmation tool. For example, a strong upward move in price coupled with a rising MFI and thus increased volume suggests that the move is likely to continue. On the other hand, a price move with a declining MFI might be unsustainable.
“Although the percentage can vary depending on your income, savings, and debts. Ideally, you’ll invest somewhere around 15%–25% of your post-tax income.”
— Mark Henry, founder and CEO at Alloy Wealth Management
Why is the Money Flow Index (MFI) Important?
As noted by researchgate, a stunning 90% of traders ultimately lose money. To avoid becoming a regular victim in the volatile market, it is necessary to increase your knowledge of using tools to increase your chances of making profits.
The Money Flow Index (MFI) is significant for several reasons, providing valuable insights into market dynamics. Here are some key aspects of its importance:
Assessing Buying and Selling Pressure
The MFI helps traders and investors gauge the volume and movement of capital flowing into or out of a security or market. For instance, during a bull market, a rising MFI may indicate sustained buying pressure, suggesting investors are confident in continued price appreciation.
In contrast, if the MFI drops while prices remain steady or rise, this divergence could signal weakening buying pressure, potentially foreshadowing a market correction. By analyzing the MFI, market participants can gain insight into market sentiment, allowing them to understand the buying and selling pressures that influence price movements.
Identifying Overbought and Oversold Conditions
The MFI is useful for detecting potential overbought or oversold conditions in a market. A reading above a certain level, typically 80, suggests overbought conditions, indicating that a correction may be imminent.
Conversely, an MFI reading below 20 signals oversold conditions, suggesting a likely upward bounce. This information enables traders to anticipate possible price reversals, such as the rebounds seen in the prices of Ethereum after the MFI fell below 20 in late 2020.
Enhancing Trading Strategies
By incorporating the MFI into their trading strategies, traders gain a more comprehensive understanding of market dynamics. For example, during periods of heightened market volatility, such as the 2020 COVID-19 market crash, traders using the MFI could have identified surges in selling pressure and timed their exits more effectively.
Conversely, during a recovery phase, like the rally in tech stocks in late 2020, a rising MFI would have signaled strong buying interest, helping traders better time their entry points. Analyzing money flow allows traders to identify periods of heightened buying or selling pressure, helping them make more informed decisions regarding entry and exit points, ultimately improving the profitability of their strategies.
Used in Combination with RSI
The MFI complements other technical indicators, such as the Relative Strength Index (RSI), by including volume data. While the RSI focuses solely on price movements, the MFI adds depth by considering trade volume.
For example, while the RSI may show overbought conditions in an asset like Bitcoin, the MFI can confirm this by revealing whether the price rise was accompanied by significant trading volume. This combination offers a more complete evaluation of market sentiment and enhances trading decisions.
Confirming Trading Signals
As it is often used alongside other technical indicators, the MFI helps validate trade signals. For instance, a bearish divergence occurs when a security, such as Bitcoin, makes higher price surge while the MFI registers lower highs, indicating a potential trend reversal.
This exact pattern was observed in late 2021 when Bitcoin’s price hit new highs, but the MFI started to diverge, signaling weaker buying momentum and preceding the sharp downturn in 2022. Basically, combining the MFI with other indicators enhances the accuracy of trading decisions.
Spotting Potential Trend Reversals
By analyzing changes in buying and selling pressure, the MFI assists traders in identifying likely trend reversals. For example, during the 2020 oil price collapse, the MFI showed a bullish divergence when prices reached historic lows, signaling a trend reversal that led to oil prices rebounding strongly in the following months.
Divergences act as early warning signs of shifts in market sentiment and potential turning points for trends.
Assessing Market Strength
The MFI provides insights into the intensity of buying and selling pressure in the market. For example, during the bull market of 2021, Bitcoin showed strong buying pressure, confirming the strength of the rally. Conversely, in early 2022, the MFI for the digital asset showed low values despite moderate price increases, indicating weakening momentum and greater selling pressure
Traders can evaluate the overall strength or weakness of a security or market by monitoring the MFI. Low values indicate greater selling pressure, while high values signify stronger buying pressure.
Comparing Securities
The MFI allows for comparisons of the relative strengths or weaknesses of different securities or markets. For instance, a trader may compare the MFI of two crypto assets, such as Bitcoin and Ethereum, to determine which is experiencing stronger buying pressure.
If Bitcoin’s MFI shows a significant increase while Ethereum’s MFI remains flat or declines, the trader might prioritize Bitcoin for potential investment. In this case, by assessing the MFI of various assets, traders can prioritize their trading opportunities based on where the money flow is strongest or weakest.
MFI Strategies
While MFI is a comprehensive indicator, it performs best when used in conjunction with other technical analysis tools. As a volume-weighted indicator, MFI primarily serves as a leading indicator.
Given its capacity to provide early signals, it is advisable to pair it with another indicator for confirmation.
In ranging markets, MFI’s overbought and oversold signals can be validated by other momentum-based oscillators like Stochastics, which also use the 20 and 80 levels to denote oversold and overbought conditions, respectively. When both MFI and Stochastics produce similar signals, it can highlight high-probability buy and sell opportunities.
As previously mentioned, MFI is effective for identifying optimal entry points during retracements in trending markets. A confluence of signals from another trend-following indicator, such as Fibonacci retracement levels, can pinpoint specific zones where a retracing market may encounter support or resistance.
When plotted, Fibonacci retracement typically highlights four key levels, with traders particularly focusing on the 38.2% and 61.8% levels for potential trading opportunities.
Different Uses of MFI
MFI can be applied to discuss various trading strategies. Here are some examples:
MFI in Stock Trading
In stock trading, the MFI is particularly useful for spotting price-volume divergences. A stock may be rising in price, but if the MFI is showing a decreasing buying volume, this could indicate an impending price correction.
For instance, consider a stock that has been rising steadily but reaches an MFI reading of 85. The trader notices a bearish divergence, where the stock’s price continues to rise but the MFI is declining.
This could signal weakening buying pressure and a potential reversal. The trader could use this information to exit their long position or enter a short position.
MFI in Cryptocurrency Trading
Cryptocurrency traders often rely on volume-based indicators due to the high volatility in crypto markets. The MFI can provide a clearer view of buying and selling pressure, especially in periods of high speculative activity.
For instance, a cryptocurrency like Bitcoin is in a downtrend, and the MFI drops below 20, indicating oversold conditions. A trader might use this as an opportunity to enter a long position, anticipating a rebound in price.
MFI in Forex Trading
Although Forex doesn’t have traditional volume data like stocks, many platforms use tick volume (the number of price changes in a given period) as a proxy. The MFI can be useful in confirming trends and detecting potential reversals in currency pairs.
“Beginner investors should think carefully through the mix of investments they’d like to have in their portfolio, as it’s good to have diversity,”
Benefits and Limitations of MFI
The Money Flow Index has several benefits but also comes with its limitations. Traders can explore both arguments and find a way to get the best out of the tool.
Benefits of Using the MFI
Calculating or monitoring the Money Flow Index can provide you with several advantages:
Volume Integration
The MFI incorporates both price and volume data, providing a more comprehensive view of market activity. By analyzing these two factors, the MFI helps traders assess the significance of price movements and validate or challenge the strength of a price change based on the associated volume.
Clear Buy/Sell Signals
The clear overbought and oversold thresholds of 80 and 20 make it easy for traders to recognize potential entry and exit points. Traders often use the MFI alongside other indicators or chart patterns to create trading signals.
For instance, they may look for a bullish crossover of the MFI above a certain level in conjunction with a breakout from a chart pattern as a potential buy signal. Conversely, a bearish crossover of the MFI below a specified level, paired with a breakdown of a chart pattern, is interpreted as a potential sell signal.
Versatility
The MFI can be used across various assets, including stocks, commodities, cryptocurrencies, and more.
Early Trend Reversals
The ability to spot divergences between price and the MFI gives traders a tool to predict potential trend reversals before they happen.
Limitations of the Money Flow Index
While the MFI offers various advantages, it also has its limitations:
False Signals
Like any other technical indicator, the MFI is not infallible and can generate misleading signals. It operates on the assumption that volume and price data accurately reflect market buying and selling pressure.
However, price and volume do not always capture the true sentiment of market participants, which can lead to false signals.
Lagging Indicator
As a lagging indicator, the MFI reacts to past price and volume data. This characteristic limits its ability to provide timely alerts for rapid market shifts or reversals.
Consequently, traders who primarily depend on the MFI may face delays in their trading decisions.
Sensitivity to Time Frame
The MFI calculation typically uses a specific lookback period, usually 14 days. The sensitivity and responsiveness of the indicator are influenced by this time frame.
Longer periods can lead to slower signals that miss immediate trading opportunities, while shorter periods may produce more frequent but potentially less reliable signals.
Limited Effectiveness in Trendless Markets
The MFI is most effective in clearly trending markets, whether upward or downward. In sideways or range-bound markets, where prices fluctuate within a narrow range, the MFI may generate conflicting or unreliable signals. Traders should be cautious when using the MFI in such market conditions.
Lack of Context
While the MFI provides insights into buying and selling pressure, it does not account for other factors that influence market dynamics, such as fundamental analysis, news events, or market sentiment.
To gain a more comprehensive view of the market, traders should consider using the MFI alongside other indicators and analytical methods. Note that no single indicator can ensure accurate predictions or eliminate all trading risks. Traders should always exercise caution, conduct thorough analyses, and consider various factors before making trading decisions.
“When it comes to investing, nothing will pay off more than educating yourself. Do the necessary research and analysis before making any investment decisions.”
Comparing MFI with RSI
The Relative Strength Index (RSI) is another technical oscillator used to measure the strength or weakness of price movements based on recent closing prices. Both the RSI and Money Flow Index (MFI) generate overbought and oversold signals that traders can use to make decisions on opening and closing positions.
The primary distinction between the two indicators is that the RSI does not factor in volume data, which is why the MFI is often referred to as the volume-weighted RSI. The MFI is typically considered to provide earlier signals than the RSI since it is a leading indicator.
However, there is no clear consensus on whether one is superior to the other; many traders use both indicators together to validate price signals.
In essence, the key differences between the two:
Volume: The MFI includes volume in its calculation, making it more sensitive to shifts in buying and selling pressure. The RSI, on the other hand, is purely based on price changes.
Thresholds: Both the MFI and RSI have similar overbought and oversold levels (80/20 for the MFI and 70/30 for the RSI), but the MFI’s volume component can sometimes lead to quicker signals.
Conclusion
The Money Flow Index is an essential technical indicator for traders looking to analyze market momentum with both price and volume data. Whether you’re trading stocks, cryptocurrencies, or Forex, the MFI can provide valuable insights into overbought and oversold conditions, trend confirmations, and potential reversals.
By understanding how to calculate and interpret the MFI, you can enhance your trading strategies and improve your decision-making process. As with all technical indicators, the MFI is best used in conjunction with other tools and analysis techniques to minimize false signals and improve trading outcomes.
FAQs
What does the MFI indicator tell you?
The Money Flow Index (MFI) is a technical indicator that evaluates buying and selling pressure by analyzing both price and volume. It ranges between 0 and 100, where values above 80 suggest an overbought condition, signaling a potential sell opportunity, while values below 20 indicate an oversold condition, signaling a potential buy opportunity.
How is MFI calculated?
The MFI is determined by first calculating the positive and negative Money Flow values, which are then used to form a Money Ratio. This ratio is subsequently normalized to create the MFI oscillator. Typically, readings below 20 are considered oversold, and readings above 80 are considered overbought.
Is MFI a leading or lagging indicator?
The Money Flow Index (MFI) can be viewed as both a leading and a lagging indicator, depending on its application and the context in which it is used.
At times, the MFI acts as a leading indicator, signaling potential trend reversals or changes in market sentiment before they occur. However, in certain situations, it may also be considered a lagging indicator, as it relies on historical price and volume data to assess money flow, thereby depending on past price and volume movements.
Who invented the Money Flow Index?
The Money Flow Index (MFI) was developed by Gene Quong and Avrum Soudack. This oscillator combines price and volume to measure buying and selling pressure and is sometimes referred to as a volume-weighted Relative Strength Index (RSI).
