- What is the MFI
- MFI Calculation
- Reading the MFI
- Trading MFI Signals
- MFI Strategies
- Trading MFI Strategies at AvaTrade
The Money Flow Index (MFI) is a technical analysis indicator that literally allows traders to ‘follow the money’. That is, this indicator measures the flow of money into and out of a security over a specified period of time. By observing the MFI, traders can determine whether there is buying or selling pressure in the underlying asset.
MFI is a momentum and volume indicator and it was created by Gene Quong and Avram Soudack. It belongs to the broader indicator group of Oscillators and its mechanics are very similar to the popular Relative Strength Index (RSI); but while RSI is momentum-based, MFI is volume-weighted. Basically, MFI is RSI with volume integrated.
MFI helps deliver overbought or oversold signals, but traders can also watch out for divergences with the price which may signal possible trend reversals.
In trending markets, MFI can also be used to identify when a trend pullback is over. Although generally an oscillator, MFI is largely a volume indicator. Some of the indicators similar to the MFI are On Balance Volume, Accumulation/Distribution and Volumes.
The MFI calculation follows 4 steps as below:
- Determine the Typical Price (TP) of the relevant time period
TP = (HIGH + LOW + CLOSE)/3
- Determine the Money Flow (MF)
MF = TP * VOLUME
If the current typical price is larger than the preceding typical price, then the money flow is positive, and vice versa. A positive flow implies that investors are building up positions on the underlying asset, whereas a negative money flow implies that investors are exiting positions in the underlying asset.
- Determine the Money Ratio (MR)
MR = Positive Money Flow (PMF)/Negative Money Flow (NMF)
- Compute the Money Flow Index (MFI)
MFI = 100 – (100 / (1 + MR))
The default time period of the MFI is 14, with the fixed minimum being 0 and the fixed maximum being 100. This means that the MFI value will oscillate between the values of 0 and 100.
Reading the MFI
Because the MFI operates as an oscillator, the basic usage will be to determine overbought and oversold levels. An MFI reading above 80 will usually imply overbought conditions in the market, while a reading below 20 would imply oversold conditions. The creators of the MFI initially recommended the 10 and 90 levels as indicators of oversold and overbought levels, but prices rarely reach these levels.
MFI traders also watch the centreline, which is at 50. A reading above 50 denotes that there is buying pressure in the market, while a reading below 50 denotes selling pressure in the market.
Trading MFI Signals
Here is how to trade the signals delivered by the MFI indicator:
- Overbought and Oversold Conditions
As mentioned above, an MFI reading of above 80, implies overbought conditions. When prices are in overbought conditions, the idea is to seek opportunities to place sell orders in the market in anticipation of a trend reversal. A reading of below 20 implies oversold conditions in the market. When prices are in oversold conditions, the idea is to seek opportunities to place buy orders in the market in anticipation of a trend reversal.
A divergence occurs when the price moves in the opposite direction of the indicator. A bullish divergence will occur when the price is edging lower, but the indicator values are surging higher. When this occurs, it implies that selling pressure is diminishing in the market and buyers are about to take over. A bullish divergence provides a potential opportunity to buy the underlying asset at a cheap price. On the other hand, a bearish divergence occurs when the price drifts higher, but the indicator values continue lower. This is a signal that buying pressure is diminishing in the market and sellers are looking to take charge. A bearish divergence offers a potential opportunity for sellers to cash out at a high price, placing a short sale order.
- Trend Pullbacks
In trending markets, the wisdom is always to join in the prevalent trend when the price makes a retracement. MFI can help traders in this regard. When there is an uptrend, an MFI drop to below 20, then back above this level, is a signal that the retracement is over, and prices are now ready to resume the bullish charge. Likewise, in a downtrend, an MFI surge above 80 followed by a drop below this level, is an indication that the retracement is now over, and prices are ready to continue with a bearish momentum.
While an overall comprehensive indicator, MFI is most effective when combined with other technical analysis tools. As a volume-weighted indicator, MFI is largely a leading indicator. Since it delivers early signals, it is important to pair it up with another indicator that will serve as a confirmation tool for MFI signals.
When trading ranging markets, MFI overbought, and oversold signals can be confirmed by other momentum-based oscillators, such as Stochastics. Like MFI, Stochastics also have 20 and 80 levels as indicators of oversold and overbought levels, respectively. In ranging markets, high probability buy and sell trading signals will be identified when both MFI and Stochastics deliver similar signals.
As mentioned above, MFI helps pick out optimal entry points when trending markets are retracing. A confluence of signals with another trend following indicator, such as Fibonacci, will help pick out definitive zones where a retracing market can find support or resistance. When plotted, the Fibonacci tool derives 4 retracement levels, with traders particularly watching out for 38.2% and 61.8%.
Trading MFI Strategies at AvaTrade
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** Disclaimer – While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.