Money Flow Index Strategy (MFI): Using It in Technical Analysis

Accurately forecasting potential reversals in financial markets can be a powerful tool as it helps traders identify favorable trade entry and exit points which can result in more profitable trading. Technical analysis tools such as Money Flow Index (MFI) can help traders identify and take advantage of potential market reversals. 

This in-depth guide explains the MFI, how it compares to other indicators like the relative strength index (RSI) and how it can be used to enhance your trading strategy.

What Is the Money Flow Index Strategy?

The Money Flow Index (MFI) strategy is a trading strategy based on the MFI — a technical analysis indicator that measures money flow into and out of an asset to gauge the buying and selling pressure. The MFI helps spot overbought and oversold conditions and assists in forecasting potential price reversals. 

The strategy revolves around the concept that buying and selling pressure changes often come before price movement. The MFI is calculated using a combination of volume and price data. It is plotted on a scale from 0 to 100, with an overbought signal showing when the value exceeds 80 and an oversold when the reading is below 20.

Money Flow Index vs. RSI

While the MFI and RSI are both popular indicators traders use to help identify overbought and oversold conditions, they have some key differences. The RSI is a momentum indicator that measures the magnitude of recent price changes to determine overbought or oversold conditions. The MFI, on the other hand, considers both volume and price. This means the MFI can provide more information about a security's overall strength and momentum than the RSI.

How to Calculate the Money Flow Index

The MFI is computed in a sequence of steps to generate an index ranging from 0 to 100. 

• First, calculate the Typical Price for each period. The Typical Price is the average of the high, low and closing prices for a specified period.
• Typical Price = (High + Low + Close) / 3
• Next, calculate the Raw Money Flow. This is the Typical Price multiplied by the volume for the period.
• Raw Money Flow = Typical Price * Volume
• Calculate the Money Flow Ratio over a given period of days (typically 14). To do this, you need to separate the Money Flow into Positive and Negative Money Flow:
• Positive Money Flow is the sum of the Raw Money Flow for the days when the Typical Price is higher than the previous day's.
• Negative Money Flow is the sum of the Raw Money Flow for the days when the Typical Price is lower than the preceding day's.
• Money Flow Ratio = Positive Money Flow / Negative Money Flow
• Finally, calculate the Money Flow Index using the Money Flow Ratio: 

MFI = 100 - (100 / (1 + Money Flow Ratio))

How to Read the MFI Indicator

Accurately reading the Money Flow Index is important  for effectively applying it to your trading strategy. Here's how you can interpret the MFI:

1. Overbought and Oversold Conditions

Generally, an MFI value above 80 suggests an overbought security, indicating that it may be overvalued and a price reversal could be imminent. Conversely, an MFI value below 20 suggests the asset is oversold, implying it may be undervalued and a price increase could be forthcoming. 

2. Divergences

Divergences between the MFI and price action can signal potential reversals. A bullish divergence occurs when the price hits a new low, but the MFI makes a higher low, suggesting that selling pressure is falling and a price increase may be on the horizon. Conversely, a bearish divergence happens when the price hits a new high, but the MFI makes a lower high, indicating declining buying pressure and hinting at a possible price decrease.

3. Failure Swings

These are another form of divergence unique to oscillators like the MFI. A bearish failure swing occurs when the MFI surpasses 80, falls below it, bounces back but fails to exceed 80 and then falls again. This signals a potential price decrease. A bullish failure swing is the opposite scenario, suggesting a possible price hike.

Using the Money Flow Index Strategy

Trading using the MFI strategy involves looking for signals that the market, either applied to a specific asset or a broad-based index, may be changing direction from overbought to oversold or vice versa. 

1. Buying an Oversold Stock

An oversold stock is typically indicated by an MFI reading below 20. Traders can use the MFI to help identify such oversold conditions, suggesting that the stock might be undervalued and could be due for a price hike. Before you consider buying the asset, you might benefit by also using other indicators and looking for a bullish divergence or a bullish failure swing. 

2. Selling an Overbought Stock

An overbought stock is generally indicated by an MFI reading above 80, suggesting an overpriced security that could be heading for a price slump. As with buying an oversold stock, it's important to identify overbought conditions with other indicators and to look for bearish divergences or bearish failure swings before deciding whether to sell. 

3. Spotting a Money Flow Index Divergence

A divergence occurs when the price and the MFI move in opposite directions, indicating a potential price reversal. Spotting these divergences can provide early signals for possible trend reversals and trading opportunities.

Possible Advantages of Using the MFI

• Incorporates volume: Unlike many other momentum indicators, the MFI includes both price and volume data, providing a more comprehensive view of market dynamics. This dual consideration allows traders to better gauge the strength behind price movements and the overall market sentiment.
• Identifies overbought and oversold conditions: The MFI can be a valuable tool for determining overbought and oversold market conditions. This can help traders better determine potential reversal points and make more informed buy or sell decisions.
• Detects divergences: The MFI can also be used to help spot divergences between price and the MFI line. Such deviations often precede reversals, providing early signals for potential trading opportunities.

Limitations of Using the MFI

• False signals: Like many other technical indicators, the MFI can give false signals. It might indicate an overbought or oversold condition but the price does not reverse as expected, potentially leading to losses.
• Lagging indicator: As a momentum indicator, the MFI is considered a lagging indicator. It relies on past price and volume data so may not always accurately forecast future price movements. This can possibly lead to missed trading opportunities or late entries and exits.
• Dependence on volume data: The effectiveness of the MFI is significantly dependent on the accuracy of volume data. If the volume data is faulty or misleading, the MFI may not provide reliable signals. Also, in markets where volume data is not readily available or is less reliable (like in the forex market), the usefulness of MFI becomes limited.

Optimizing Trading with the Money Flow Index Strategy

The Money Flow Index (MFI) strategy can be a valuable tool for traders, providing insights into market trends and potential overbought or oversold conditions. It uses both price and volume data to measure the inflow and outflow of money into a security. But like any tool, it has limitations, such as the potential for giving false signals, being a lagging indicator and its heavy reliance on accurate volume data. While the MFI can be a key component of a trader's toolkit, it's most effective when combined with other technical and fundamental analysis tools.

Frequently Asked Questions