Description: The Money Flow Index or popularly called the MFI is a momentum oscillator that helps us to gauge the flow of money into and out of a security. Developed by Gene Quong and Avrum Soudack, MFI uses the Relative Strength Index (RSI) formula in its calculation with proper weightage to the volume component. Hence, it is also referred to as the volume-weighted RSI sometimes. The Money Flow Index (MFI) oscillates between a scale of 0 to 100.
Money Flow Index (MFI) Calculation
The calculation of the Money Flow Index involves several steps.
Step 1. Typical Price = (High + Low + Close)/3
Step 2. Raw Money Flow = Typical Price x Volume
Step 3. Money Flow Ratio = (14 Period Positive Money Flow)/ (14 period Negative Money Flow)
Step 4. Money Flow Index = 100 – 100/(1 + Money Flow Ratio)
Quong and Soudack recommended using 14 periods in the calculation of the MFI which is also the standard default setting in various charting software.
As the Money Flow Index is a volume-weighted version of the RSI indicator, its interpretations are also very similar to that of the RSI. However, due to the presence of the volume component in its calculation, MFI becomes more leading in nature when compared to the RSI.
The Money Flow Index (MFI) can be used to generate various types of signals. They are as follows:
Overbought & Oversold: A reading above 80 on the MFI is considered as overbought, while a reading below 20 is considered as oversold. Both of these readings indicate towards price extremes that are unsustainable and likely to reverse. However, in the face of strong uptrend or strong downtrend, these levels aren’t of much use. Quong and Soudack recommended using 90 as the truly overbought and 10 as the truly oversold threshold. Although such occurrences are rare, they make for more filtered signals when combined with other technical context.
Divergences and Failure Swings: Combining divergences and failure swings on the Money Flow Index (MFI) can result in the generation of very powerful signals.
A bullish divergence on the MFI occurs when price makes a lower low but MFI refrains from making one and instead forms a higher low. If during the first low MFI dips below the 20 oversold level and holds above it during the second low in price and then breaks above the previous reaction high on the MFI, we have a bullish divergence in place.
On the other hand, a bearish divergence on the MFI occurs when price makes a higher high but MFI refrains from making one and instead forms a lower high. If during the first high MFI goes above the 80 overbought level and holds below 80 during the second high in price and then breaks below the previous reaction low on the MFI, we have a bearish divergence in place.
Money Flow Index (MFI) is a very robust indicator that takes into account both momentum and volume in its calculation.
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