A Practical Guide to the Money Flow Index

The Money Flow Index (MFI) is one of the most relevant indicators when it comes to understanding the role that volume plays in different markets. Created by Gene Quong and Avrum Soudack, it is also known as volume-weighted RSI. We will introduce this indicator in this text by understanding how it works and what the intention behind it was and, on the other hand, through the different information it provides us – and the opportunities to trade that can emerge through its use.

 

Money Flow Index: The Basics

money flow index indicator

 

Why is this indicator relevant and how it is associated with the famous RSI? Well the intention of the creators of the MFI was to associate the power of volume flows on the one hand and the power of RSI – that measures the average gain of up periods and the average loss of down periods during a particular time.

 

Unifying these two concepts allowed for the creation of an indicator that on the one hand tracks volume flows – and therefore aims to register particular oscillations of demand/supply orders in the market – and, on the other, is also able to statistically understand the rate of growth of price during the day.

 

The result of this effort is an oscillator that is able to capture prices moves within a range of 0 and 100. Conditions approaching extremes are particularly relevant for its use.

 

Can we Trade using Money Flow Index?

money flow index divergences

 

This is the million-dollar question and again – as in so many other occasions – there is no definite response to this question. This indicator should always be used with discretion and never as in itself providing the trader with exact orders to enter or exit the market.

 

We can use this indicator to identify mainly two conditions of the market. These conditions can, in association with a broader understanding of volume that is provided by our trading course, give us insights into a trading strategy.

 

Reversals. Extreme values in MFI are indicative of potential reversals in the market. When the price moves to an extreme value it essentially means that not only are there higher volumes of capital in the market but also that they achieved relative gains that are also extreme. Joining volume and RSI allows for this conclusion.

 

So when the indicator shows an overbought condition – above 80 – or oversold condition – below 20 – the trader should be on alert for a potential reversal. Being an oscillator, the MFI is, therefore, a powerful solution to get a better grasp of what goes on in the market and whether price has achieved extreme values.

 

Divergences. But there is also another way to use MFI – through an assessment of divergences of price and the values showed in the indicator. So let’s just assume that price achieves an overbought condition (above 80), and then continues in the same direction but the MFI shows a lower value. This essentially means that even though price has continued to move higher, the volume is drying and the relative gains are statistically inferior. The trader should be aware that this divergence between price and indicator is another potent sign of reversal.

 

The same occurs for oversold conditions (below 20). When price continues to move down but the MFI starts to climb above the oversold condition, this indicates a possible reversal of price.

 

What not to Expect from the Money Flow Index?

 

The MFI is not a holy grain. It cannot by itself explain and give you a trading strategy. It needs to be combined with the analysis of price and with other indicators to understand whether there is a potential opportunity for investing.

 

Like so many other technical indicators, the MFI is a lagging indicator. This means that it cannot track current information but its updates lag behind real time. It runs after price and not alongside or in front of it. This is its deficiency.

 

By understanding this, the trader needs to complement the use of the MFI with other sources of information.

 

Conclusion

 

The MFI is a powerful indicator. Created to link both volume and relative gains within a particular time and timeframe, it gives important signs of extreme values and divergences in the market. The trader should always be aware that this information is relevant but does not provide by itself entry or exit signals.

 

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