Definition of the Money Flow Index Indicator
Components of the Money Flow Index
The Money Flow Index is made up of three components.
The calculation of the Money Flow Index is by multiplying the typical price by the volume:
Usage of the Money Flow Index in Trading
a)As a standalone indicator
b)In combination with other indicators
Conclusion
The Money Flow Index is an indicator that utilizes
the volume and volatility of an asset to determine the buying or selling
pressure of an asset. The indicator was developed by Avrum Soudack and
Gene Quong as a volume-weighted variation of the RSI.
The Money Flow Index is calibrated from 0 to 100, and
creates a money flow ratio (Positive Money Flow to Negative Money Flow)
over a time period. This money flow ratio is what is pushed into an RSI
formula to create a momentum indicator. Being a momentum indicator, the
Money Flow Index (MFI) is capable evaluating overbought and oversold
market conditions, using values of 80 and above for overbought
conditions and 20 and below for oversold situations.
Money flow is deemed to be positive when there is
increased buying pressure, leading to rise in price of currency pair.
Money flow is negative when there is increased selling pressure, leading
to drop in price of currency pair.
MFI can also be used for divergence trades, as divergence between peaks and troughs of the MFI and the price action can produce trading signals.
The Money Flow Index is made up of three components.
a) The indicator line which is a measure of price and volume weighting set to 14 periods.
b) Overbought zone
c) Oversold zone
b) Overbought zone
c) Oversold zone
The calculation of the Money Flow Index is by multiplying the typical price by the volume:
Typical Price = (High + Low + Close) / 3
MFI = Typical Price X Volume
Usage of IndicatorMFI = Typical Price X Volume
The Money Flow Index shares resemblance to the
Relative Strength Index, so it can be used in the ways the RSI is used.
More importantly, it also incorporates the volume of trade by buyers and
sellers into the calculation, so it is capable of producing trading
signals much earlier than the RSI can.
The Money Flow Index can be used in trading in the following ways:
As a standalone indicator, the Money Flow Index can
be used in divergence trades. The divergence in this case would be to
look to see where the peaks and troughs of price action deviate from the
peaks and troughs of the Money Flow Index. Trend lines are used to
connect the peaks and troughs of both price action and the MFI. Whenever
a divergence is detected, it represents a trading opportunity as price
action will try to correct the divergence. The divergence situation is
seen when the trend lines of price and the RSI are facing different
directions. The entry for any divergence trade must be made using
technical parameters such as candlestick or chart patterns.
The example above shows a typical divergence trade.
The MFI is showing higher lows while the price action is making lower
lows. This is a bullish divergence and price is expected to correct
upwards to tally with the MFI. After identifying the divergence, the
trade is setup after we identify a pinbar entry candle. The exit point
of this trade is when price gets to levels identified by the MFI as
being in overbought areas. Note that the divergence trade was setup when
price was oversold, so this was a good trade on the 4hour chart of the
GBPJPY, netting 356 pips.
The primary way is to trade the MFI in combination
with other indicators is when trading overbought or oversold market
conditions. When the MFI is 80 or >80, the market is overbought and
this is a bearish signal. When the RSI is 20 or <20, this is an
oversold signal and the trader would be looking to short the currency
pair.
Here, you could add the coloured MACD indicator
and look for something on the charts that would support a short entry
when the MFI is overbought, or a long entry when the MFI is oversold.
This is the daily chart of the GBPJPY. We have a
rising wedge forming when the MFI is overbought. The short trade is
initiated at the open of the next candle which breaks the lower border
of the rising wedge. We also see the coloured MACD indicator showing a
red candle bar, which confirms the short entry. The trade is taken and
exited when the coloured MACD bars show blue or when the MFI gets into
oversold territory. This trade would have netted about 300 pips.
Make sure you practice how to trade each setup on a
demo account before using the indicator to trade real money. Also pay
attention to risk management.
