Money Flow Index: What is and How to use it [Guide]
The Money Flow Index is a momentum indicator that provides information on the amount of money that is used to buy and sell a stock over time.
It is designed for traders looking for price reversal points in a market, but it is not very useful when there is a strong one-way trend.
Let’s see the key points of the Money Flow Index:
- Money Flow Index (MFI) is a technical indicator that generates overbought or oversold signals using both price and volume data
- An MFI reading above 80 is considered overbought and an MFI reading below 20 is considered oversold, although levels of 90 and 10 are also used as thresholds
- The divergence between the indicator and the price must be taken into strong consideration
In this guide we will explain in detail what the MFI is and what it is used for. For this reason you will need a trading platform where you can view it and test it, better without risking money.
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Money Flow Index: what is it?
What is the Money Flow Index (MFI)?
It is a momentum indicator as we have said and measures the amount of money used to buy and sell a stock in a given period of time.
It is related to the Relative Strength Index (RSI) but incorporates the volume, while the RSI only considers the price.
The MFI is calculated by accumulating positive and negative flow values, then creating a monetary ratio, which is displayed by the indicator in the form of an oscillator.
Difference between Money Flow Index and Relative Strength Index (RSI)
The MFI and the RSI are closely related.
The main difference is that the MFI embeds the volume, while the RSI does not. Traders who frequently analyze volume find it a very important indicator.
In essence, the MFI warns of the approach of a probable trend reversal more effectively than the RSI.
They are correlated but not superimposable indicators, the signals they produce are different and both can be used to obtain more precise indications.
How to use the Money Flow Index
We also mentioned this at the beginning of our guide, to take advantage of the Money Flow Index you need a trading platform. CFD brokers make them available for free to their members, so they are the ideal solution to learn how to use this indicator.
The CFD brokers that we offer are safe, with regular licenses, allow you to trade without commissions and to invest both up and down (sell short).
Learning to use a new trading indicator is not easy and the best way is to see how experienced traders do it.
Copying the best traders
This is why we recommend to register to eToro which has the largest community of traders in the world (over 10 million) and through Social Trading allows these investors to communicate with each other, exchange information and learn.
Social Trading is a social network of investors, perfect for learning how to use the Money Flow Index and any other indicator.
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Learn from a great Trading Course
Observing how the more experienced traders use the Money Flow Index is essential but then you also need a bit of theory to understand what they are doing.
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The pdf explains in a simple but detailed way the rules underlying online trading and the most effective strategies, including those involving the use of the MFI.
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Money Flow Index Formula
The Money Flow Index formula is as follows:
MFI = 100 – [100 / (1 + Monetary ratio)]
Obviously this formula alone will not tell you much but to better understand what the MFI actually measures, let’s see how it is calculated:
Money Flow Index calculation
The Money Flow Index can be calculated using the following steps:
- The typical price is calculated for a period
- Typical Price = (Low + High + Close) / 3
- If today’s typical price is higher than yesterday’s, this implies a positive cash flow
- If the typical price is lower, it implies a negative money flow
- It is necessary to calculate the flow of raw money
- Raw cash flow = volume x typical price
- The monetary ratio is calculated
- Monetary ratio = 14-period positive cash flow / 14-period negative cash flow
- Then you need to calculate the Money Flow Index (MFI)
- MFI = 100 – [100 / (1 + Monetary ratio)]
We have divided the formula into steps to make it easier to understand but you don’t need to know it to use the MFI, you just need to understand how the indicator works.
The trading platforms will do all the calculations for you and turn them into a line on a chart.
How does the Money Flow Index work?
Now let’s try to better explain how the MFI works, perhaps also using some examples.
When the price of a stock increases, the Money Flow Index indicator also increases and is a sign of greater buying pressure.
Conversely, if the share price falls, the MFI indicator will also decrease and is a sign of selling pressure.
So thanks to MFI you can easily predict directional momentum in the market with great accuracy.
If the Money Flow Index shows an indication above 80, you need to be careful because the uptrend could be in an overbought condition. This condition denotes instability and often generates a short-term retracement or even a trend reversal.
Conversely, when the MFI falls below 20 points the downward trend is going oversold and will likely lose strength. This means that we can expect an end of the trend or at least a short-term correction.
Money Flow Index Limits
Like all trading indicators, the Money Flow Index can also produce false signals.
When the indicator goes above 80 or below 20, something does not always happen, sometimes the trend is so strong that it remains overbought or oversold for a long time.
Opportunities to enter or exit a trade must be carefully considered and confirmations are needed. For this reason, the MFI is often used together with other indicators such as Moving Averages, Stochastic, CCI, ATR, etc.
In addition to producing false signals, the MFI may not detect trend reversals that do not lead to significant overbought or oversold situations.
When you notice divergences between market prices and the MFI indication, you must check if this “contrast” is significant. Always look for confirmation of at least one other indicator before entering the market.
Money Flow Index Strategy
As we have said, the Money Flow Index is a momentum oscillator, so it is used to confirm or not the price action.
If the MFI is falling and the other indicators in your trading platform are signaling a downtrend, the odds of the stock price going down are much higher.
Conversely, you can aim upwards if the MFI is rising and there are other indicators to signal the uptrend or at least the end of a downtrend.
This is the classic method of using the Money Flow Index which essentially fluctuates.
But in some trading strategies the MFI is used by examining the divergences, or the inconsistency of the indications given by the indicator and those that are seen in the price chart.
For example, if in the graph you see the stock price rising but the MFI is falling, it could mean that the uptrend is weakening.
The same thing obviously concerns the opposite, i.e. a bearish trend and a divergent MFI which is increasing instead.
As with the classic use of the MFI, even with divergences, false signals are likely and confirmations from other indicators are needed.
But now let’s see some trading strategies with the Money Flow Index:
Buying oversold shares with the MFI
The chart above clearly shows Microsoft’s stock price in an oversold situation, reported by the MFI.
Oversold was very strong and in fact heralded a reversal of the trend.
To enter the market, it is advisable to wait for the Money Flow Index to rise above the 20-point line and for the price to have reversed its previous direction.
The purchase order can also be anticipated but if the MFI is expected to return above 20, numerous false signals are filtered out.
Sale of overbought stocks with the MFI
In this example we see the share price of Radius Health Inc showing a strong divergence with the Money Flow Index.
The stocks were in a strong bearish trend as the MFI was rising. This divergence can be exploited for an upward entry but there must be another indicator to confirm the reversal.
Otherwise, the breach of the 80 line shows again an overbought which manifests itself in the prices with a very rapid upward gap.
This is a strong sell signal but beware of false signals, before going down you must be sure that this is not the beginning of a new uptrend but simply an “adjustment” of the previous downtrend.
Identification of a divergence in the Money Flow Index
We also saw a divergence in the previous graph but everything is much clearer here.
This is a chart that always shows Radius Health Inc. prices with a bearish divergence after the Money Flow Index reading has risen above 80.
As a result, the stock price has not only retraced but has actually reversed course by transforming itself from an uptrend into a clear downtrend.
The input signals, also in this case, must find confirmation in at least one other indicator.
The Money Flow Index, as we have seen, does nothing but indicate the relationship between positive and negative money flow, also incorporating volumes.
Basically, the MFI signals possible trend reversals with a certain notice, but you must always look for confirmation in other indicators before entering the market.
The strategies based on the MFI are effective but complex, for this reason we recommend that you always keep the ForexTB Trading Course at your disposal to consult it whenever you have a doubt.Download the Trading Course for free by clicking here
As with all indicators, even to learn how to use the Money Flow Index you need to practice, better without taking risks.
Start with one of the virtual money Demo accounts offered by the most used CFD Broker in the world: eToro.
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The MFI is a momentum indicator that provides information on the amount of money used to buy and sell a stock over time.
The MFI = 100 – [100 / (1 + Monetary ratio)], a complex formula, find more details in our guide.
The MFI can be used in many strategies, the main ones we have shown in our guide.
To make the most of this indicator you need a trading platform, preferably a high-level one such as that of eToro.