Description: When it comes to trading, one of the most essential, yet oft-neglected piece of information is volume. While amateurs look at only the price charts trying to figure out the next probable move through wild guesses, professionals keep track of the money that is flowing in and out of a scrip to take informed trades based on sound research. One such indicator that helps us to gauge the flow of money in and out of a security is the Money Flow Index (MFI) which was developed by Gene Quong and Avrum Soudack.
The Money Flow Index (MFI) is basically a volume-weighted variation of the Relative Strength Index (RSI) and hence is also known by the name of volume-weighted RSI.
The Money Flow Index is calculated through several steps. They are as follows:
Step 1. Typical Price = (High + Low + Close)/3
Step 2. Raw Money Flow = Typical Price x Volume
Step 3. Money Flow Ratio = (Positive Money Flow over 14 periods)/(Negative Money Flow over 14 periods)
Step 4. Money Flow Index = 100 – 100/(1+Money Flow ratio)
The Money Flow Index (MFI) can be used in various ways to generate trading signals. Here we will discuss a simple yet very effective trading strategy that is based on the 14-period MFI and a 50-day simple moving average.
When price is trading above the 50 DMA, it indicates that the upward momentum in the stock is intact. We consider trades only from the long side. We go long when the 14-period MFI retraces to the 60 level from above, tests it, and eventually closes above it.
In the above example of Tata Steel, we can see how BUY signals were generated by the 14-period MFI as it retraced back to the 60 level, tested it and eventually closed above it, al while prices were trading above the 50 DMA.
Similarly, when price is trading below the 50 DMA, it indicates that the downward momentum in the stock is intact. We consider trades only from the short side. We go short when the 14-period MFI retraces to the 40 level from below, tests it, and eventually closes below it.
In the above example of AuroPharma, we can see how SELL signal was generated as the 14-period MFI retraced back to the 40 level, tested it and eventually closed below it, all while prices were trading below the 50 DMA.
To conclude, we can say that MFI is a very powerful indicator that helps us to gauge the flow of money in and out of a stock with the help of volume analysis. Given the fact that volume is the fuel of the market that drives the prices, it is of quintessential importance to learn how to make sense of the volume figures properly and trade profitably.
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