What Is The Money Flow Index (MFI) in Trading?

FXOpen

The Money Flow Index (MFI) is an indicator that measures the flow of money into and out of a particular financial asset and provides insights into the strength and direction of price trends. It’s an oscillator, like the RSI, Stochastic, and Awesome Oscillator. Moreover, it provides similar signals to the Stochastic. Is it worth learning about? Definitely, and in this FXOpen article, we will explain why.

What Is the Money Flow Index?

Developed by Gene Quong and Avrum Soudack, the MFI combines price and volume data to gauge the buying and selling pressure in the market. What is the Money Flow Index definition? The MFI is categorised as an oscillator, meaning that it fluctuates between 0 and 100, indicating overbought and oversold conditions. Traders often use it to identify potential reversal points and generate buy or sell signals. The Money Flow Index is used in crypto*, forex, and commodity markets. You can use it to analyse stock money flow data.

Money Flow Index Formula

To calculate the Money Flow Index, several steps are involved. Let's break down the formula:

  • Typical Price (TP): This is the average of the high, low, and closing prices for a specific period.
  • Money Flow (MF): This step calculates the amount of money flowing into or out of the asset.
  • Positive Money Flow (PMF): This stands for the money flow on days when the current typical price is higher than the previous one.
  • Negative Money Flow (NMF): This stands for the money flow on days when the current typical price is lower than the previous one.
  • Money Ratio (MR): This measures the ratio between positive and negative money flows.
  • Money Flow Index: Finally, the MFI is calculated by normalising the money ratio and converting it into a value between 0 and 100.

The MFI is typically calculated over a period of 14 days, but this setting can be adjusted to suit different trading strategies and timeframes. The common rule is that a shorter period suits strategies where a trader opens trades very often as the oscillator generates signals frequently, while a longer period is used by traders who aim for longer-term trades as the oscillator generates signals rarely, but they are considered more reliable.

How to Use the MFI in Trading

By providing insights into buying and selling pressure, the MFI helps traders identify overbought and oversold conditions, divergences, and failure swings, which can be used to generate potential trading signals.

Overbought/Oversold Conditions

As the MFI is an oscillator that fluctuates within a specific range, it’s quite easy to identify overbought/oversold market conditions using it.

When the MFI rises above 80, it indicates an overbought condition, suggesting that the asset may be due for a price correction or a downward trend. An overbought condition implies excessive buying pressure, and a reversal in price might be imminent. Conversely, when the MFI drops below 20, it signifies an oversold condition, indicating excessive selling pressure and a potential upward price reversal.

It's important to note that overbought or oversold conditions alone do not guarantee an immediate change in price direction. Traders wait for the oscillator to exit the overbought/oversold zone before they open a trade. When the MFI rises above 20, it’s usually considered a “buy” signal, while a fall below the 80 level may be considered a “sell” signal.

In the Money Flow Index chart above, the indicator left the overbought area (1) before a solid downtrend started. A trader could use the MFI signal to enter a short trade; however, the index entered the oversold area (2), which could be considered a sign of a trend reversal, but the reversal didn’t happen, and the price continued moving down.

Note: Oscillators can test overbought/oversold areas several times before an actual reversal occurs. Moreover, the indicator may provide incorrect signals in strong trends. Therefore, traders never use the indicator without a confirmation received from other technical analysis tools or fundamental data.

Divergences

MFI divergence occurs when the price and the MFI move in opposite directions. This can be bullish or bearish, providing valuable insights into potential trend reversals. Bullish divergence happens when the price forms lower lows while the MFI forms higher lows. This suggests that despite the price declining, buying pressure is increasing, indicating a possible upward movement. Conversely, a bearish divergence occurs when the price forms higher highs while the MFI forms lower highs, indicating a potential downward movement.

In the chart above, the price formed a bearish divergence with the Money Flow Index, and the price declined significantly.

Failure Swings

Failure swings, also known as "bullish failure swings" or "bearish failure swings," are powerful signals generated by the Money Flow Index. A failure swing occurs when the MFI reaches overbought or oversold levels and then fails to surpass its previous peak or trough. This failure to exceed previous levels suggests a weakening of the prevailing trend and the possibility of a reversal.

In a bullish failure swing, the MFI drops below the oversold level, rallies, manages to stick above the oversold area, although the price sets a new low, and then makes a new high. This indicates that despite the initial selling pressure, buyers are stepping in, creating a potential buying opportunity.

Conversely, in a bearish failure swing, the MFI rises above the overbought level, declines, manages to stick below the 80 level although the price makes a new high, and then makes a new low. This shows that despite the initial buying pressure, sellers are entering the market, signalling a potential selling opportunity.

In the chart above, the price was moving in a strong downward trend, but the MFI didn’t enter the oversold area after leaving it at the end of October. Once the indicator broke its previous high (1), a trend reversal was confirmed.

Failure swings aren’t a common signal that traders use when trading with the Money Flow Index. However, they can be an additional tool to confirm price movements. To practise and develop your own Money Flow Index strategy, you can use the free TickTrader platform that implements over 600 trading instruments that you can trade with FXOpen.

Final Thoughts

The Money Flow Index is an effective indicator. Its signals are straightforward, and it has only one parameter, a period; therefore, even a trader with little experience will be able to customise it so it empowers their trading strategy. Although the calculations seem complicated, the tool is built to run automatically on trading platforms.

Still, traders need to remember that the Money Flow Index should be used as part of a comprehensive trading plan and combined with proper risk management techniques. Traders can practise using the MFI on a demo account or backtest it on historical data to gain familiarity and confidence before applying it to live trading. When you feel comfortable with the indicator, you can open an FXOpen account.

*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.

This article represents the opinion of the Companies operating under the FXOpen brand only. It is not to be construed as an offer, solicitation, or recommendation with respect to products and services provided by the Companies operating under the FXOpen brand, nor is it to be considered financial advice.

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