The money flow index (MFI) is a powerful tool for every trader with a trend-based trading strategy. The MFI can be used to generate trading signals and to improve on current signals by stopping you from investing in a weak movement.
What is the Money Flow Index?
The MFI measures how much an asset is traded and whether there is more money flowing into the asset or out of it. The result can be used as a measure for the market’s enthusiasm about a stock.
The MFI is an oscillator. Its value ranges from 0 to 100. The higher the value, the more money is flowing into the asset in relation to the money that is flowing out of the asset. Generally, a value of 80 or above indicates an overbought asset, a value of 20 or below indicates an oversold asset. Most commonly, the MFI is calculated over the last 14 periods. You can, however, adapt this setting to suit your preferences and your trading strategy. Usually, the MFI is displayed in a separate window, not in your main price chart.
The MFI is calculated in 4 steps. First of all, the typical price for each period is calculated as the average of high, low, and close of the period. Secondly, the typical price is multiplied with the volume of the period. Thirdly, the results of all periods with rising prices are added up and divided by the results of all periods with falling prices. This will generate the money ratio. Finally, the money ratio is converted into a percentage and forms the MFI.
MFI = 100 – 100 / (1 + money ratio).
How to trade the MFI
You can use the MFI to judge the energy a trend has left. In its most basic form, you can use the MFI to stop investing in long options when the MFI’s value is over 80, and stop investing in short options when the MFI is below 20.
This trading strategy would work on the basic assumption that, once every trader willing to buy an asset has bought, there is no upwards energy left for prices to continue to rise. Therefore, the asset has to go through a period of consolidation to generate new momentum. These periods feature erratic price movements and are difficult to trade with a trend-based strategy. The MFI can help you identify such periods. Vice versa, this logic can be adapted for falling prices: When the MFI falls below 20, every trader willing to sell has sold. Therefore, the asset cannot fall further.
Similarly, you can try to find differences between the MFI’s movement and the price movement of the asset. When prices create a new peak, for example, but the MFI is still lower than its last peak, this could indicate a weakening trend and an imminent reverse. In this case, you should not invest in rising prices. Vice versa, when prices create a new bottom without the MFI creating a new bottom, this could indicate a weakening downtrend.
An especially significant trading signal is generated when the MFI moves into the opposite direction of the price. In this case, a turnaround in price direction usually is imminent.
As alert readers of articles here on BinaryOptionsStrategy.net you will have noticed, the Money Flow Index is very similar to the relative strength index (RSI) in calculation and use. Both use the total up days in relation to the total down days to judge a trend. The RSI, however, uses the price change for his calculation, while the MFI uses the volume. Which of the two indicators you prefer is entirely up to your preferences. By design, none is better than the other.