What is the money flow index and how does it work?
What is the money flow index (MFI)?
The money flow index (MFI) is a technical oscillator that measures the inflow and outflow of money into an asset over a period of time. It looks at both price and volume to assess the buying and selling pressures in a given market.
Analysts found that volume alone was not a clear gauge of momentum – what traders should really be interested in is the market response to price changes. This is why the MFI also looks at price movement to confirm whether there is a stronger momentum upwards or downwards, indicating the sentiment of the market.
How does the money flow index work?
On the tastyfx platform, if the MFI exceeds 80, the line will show as red, and if it falls below 20, it will appear green.
The theory behind the MFI indicator is that when these levels are met, the market price could soon reverse, and traders should think about opening a position to take advantage of the momentum.
It is also important to keep an eye out for points where the price of an asset and the money flow index are giving contradictory signals – this is known as a divergence. For example, if the price is making new highs, but the MFI doesn’t reach corresponding new levels, this would be a bearish divergence. It indicates there may soon be a selling pressure. However, if the price falls to new lows, but the MFI doesn’t follow that movement, it may be an indicator of a bullish divergence and an impending buying pressure.
It’s worth remembering that a divergence does not always result in a reversal. The MFI can produce false signals – these occur when the indicator presents a good trading opportunity, but the market price does not move as expected. This can result in unexpected losses if a trader hasn’t implemented a suitable risk management strategy.
Money flow index calculation
Most traders will never have to calculate the MFI themselves, as usually online platforms will do this automatically. But knowing the steps involved in calculating the MFI is a great way to understand exactly what the indicator is showing you.
Although the MFI formula can appear complex, once broken down, it becomes an accessible way of measuring market conditions. We’ve outlined the process for calculating the MFI in five simple steps:
The typical price is calculated
To calculate the typical price for each trading period, you need to find the average of the high, low and closing price. The calculation for this would be:
The raw money flow is calculated
The raw money flow is simply the approximation of how much capital was passed through a market in a given period – whether this was buying the asset or selling it. It is calculated by taking the typical price and multiplying it by the volume for that period.
The volume is usually measured using the tick volume, which represents the amount of price changes over a given period of time. This is because not every market gives real volume reports – which provide data on how many times an asset is bought and sold.
The positive and negative money flows are calculated
Once you have calculated the raw money flow, you will be able to determine if it is positive or negative. This is done by marking whether the raw money flow in a given period is higher or lower than the period before.
If the typical price for the period is higher than the previous period, it is considered a positive money flow and if it is less than the previous period’s price, it is considered a negative money flow.
The money flow ratio is calculated
Once you have your positive and negative money flows, you can calculate the money flow ratio. You’d do so by adding up all the positive money flows over the last 14 periods and dividing this number by the sum of the negative flows for the last 14 periods.
The equation looks like this:
The money flow index is calculated
Now that you have found the money flow ratio, you can calculate the MFI. The money flow index formula is:
The MFI figure will be positive if the asset’s price has predominately risen during those 14 periods, indicating buying pressure, and negative if the price has largely declined, showing a selling pressure.
Why should traders care about the money flow index?
Traders should care about the money flow index, as it can help to identify potential reversals when overbought and oversold signals are shown. It can be a key measure of the market sentiment surrounding an asset, as the MFI can show trader enthusiasm or indifference.
Like other volume-based analysis tools, the MFI is considered a leading indicator, so it can be used to predict market movements. However, it is important to remember that leading indicators are not entirely accurate. So, they should always be used in conjunction with other forms of analysis, and alongside a suitable risk management strategy.
Money flow index vs relative strength index
The relative strength index (RSI) is another technical oscillator, which is used to chart the strength or weakness of price movements based on the closing prices of a recent trading period. Both the RSI and MFI provide overbought and oversold signals, which can be used by traders to open and close positions.
Learn more about the relative strength index.
Where the two technical analysis tools differ is that the RSI does not incorporate volume data. This is why the MFI is often known as the volume-weighted RSI. The MFI is often thought to provide earlier signals than the RSI as it is a leading indicator. However, there is no consensus as to whether one is better than the other – in fact, many traders will use them both to confirm any price signals.
Money flow index summed up
To help you understand the money flow index, we’ve summed up a few key points:
- The money flow index (MFI) is a technical oscillator that measures the inflow and outflow of money into an asset over a period of time
- The MFI is usually calculated using 14 periods of price data
- The MFI calculation incorporates the trading volume, the typical market price and monetary flows for the given period. The final figure is presented on a scale between zero and 100
- If the MFI reading is above 80, the market is often thought to be exhibiting overbought conditions, while an MFI reading below 20 can be an indicator of oversold conditions
- When these levels are met, it is an indication that the market price might soon change direction
- Like other volume-based indicators, the MFI is considered a leading indicator, so it is used to predict price movements
- The MFI is related to the relative strength index (RSI), as both identify overbought and oversold conditions. However, the RSI does not use volume data
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