The Money Flow Index is a common indicator for measuring the momentum of a security, based on monetary inflow and outflow. Learn everything you need to here!
The Money Flow Index (MFI) is a way to measure a security’s momentum by revealing the money flowing into and out of it across a specific period of time.
MFI is synonymous with volume weighted RSI (relative strength index) — it integrates volume and is highly similar with regards to its mathematical formulation and categorical classification as a momentum oscillator. Price and volume data both feature in its calculation.
So, how is it calculated?
How the Money Flow Index is Calculated
The MFI oscillates on a 0 – 100 scale, and its default setting is 14 periods. It’s typically used with the daily chart: for chartists, this is the most common time compression. Often, volume isn’t kept on charting software platforms beneath the daily level, which means the Money Flow Index might need to be utilized on the daily time compression or above (such as weekly or monthly).
Step 1:
As with certain other indicators, the Money Flow Index is dependent on a calculation of the typical price, which is worked out in the following way:
Typical price = (high price + low price + close price) / 3
The commodity channel index and Keltner channels alike also use the typical price.
Step 2:
The next step is calculating money flow (sometimes known as “raw money flow”). This is a function of volume and the typical price:
Money Flow = volume x typical price
Step 3:
This focuses on the ratio between positive and negative money flow, a formula that’s equal to:
Money Flow Ratio = (N-Day Positive Money Flow) / (N-Day Negative Money Flow)
Here, N will be equal to the amount of periods to which the indicator is set, which will be 14 if choosing to keep the default settings in place.
When calculating positive money flow, take the sum of all the money flows from the days where the price of one day is higher than that before it. Likewise, you can calculate negative money flow by taking the sum of all money flows on days where the typical price of one day falls below that of the one before.
Step 4:
Once you’ve completed these three calculations, you can find the MFI by using this formula:
Money Flow Index = 100 – 100 / (1+ money flow ratio)
This value will lead to a value of somewhere between 0 and 100 every time.
However, bear in mind that volume data isn’t kept for currency pairs on most charting platforms. The Money Flow Index won’t plot on charts without volume.
How to Use the Money Flow Index
Traders who incorporate volume into their analysis tend to search for divergences between price and volume. So, if volume trends one way and price the opposite, this may be a key indication of an impending shift in the market’s direction.
A lot of technical analysts believe volume is followed by price, so if volume trends down while the price trends up, certain traders feel that price will probably reverse trend to eventually match volume. As the Money Flow Index integrates volume data into it, traders can apply meaning to divergence occurring between the direction of the price and indicator.
For example, when looking at MFI on your platform, you will notice there are horizontal lines of different colors (often green and red): it’s believed that when the Money Flow Index reaches beyond 80, a security is considered “overbought”, but it’s “oversold” when the MFI indicator sits beneath 20.
It’s likely that traders would feel biased toward long trades if a specific market becomes oversold, and toward short trades in overbought markets. A price reversal is based on the possibility of mean reversion or a distorted market going back to normality over time. And if the MFI and price are divergent, and this works to the trade’s benefit (i.e. market is overbought, price trends up while MFI trends down), it’s an even better outcome.
Regardless, the Money Flow Index should never be used in isolation for trade signaling. Instead, it’s better utilized along with other indicators and tools to help you make smart trading choices based on quality information.
Conclusion
As a popular momentum indicator, the MFI offers traders insights into the amount of funds flowing into and out of a security during a particular timeframe. It’s made for traders trying to pinpoint price reversal in a market, and isn’t a valuable addition to a trend following system.
It’s recommended that the Money Flow Index be leveraged in conjunction with other indicators of price reversals, such as Keltner channels or Fisher Transform) to filter false signals and improve the accuracy overall.
