Trading With The Money Flow Index (MFI)

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Trading With The Money Flow Index (MFI)


 

The Money Flow Index (MFI) is a modified RSI indicator with an additional volume component. Put simply, think of the MFI as RSI that accounts for volume divergences.

The Money Flow Index (MFI) is a prevalent indicator used by investors and day traders alike. It is one example of a classification of indicators in technical analysis that measure volume flows.

The MFI was initially developed by two analysts, Avrum Soudack and Gene Quong. Avrum and Quong took Welles Wilder’s popular oscillator, the Relative Strength Index (RSI), and applied a volume calculator to Wilder’s original indicator.

The MFI is one of many other indicators that have been created where additional data is applied to Wilder’s original RSI formula.

Another example of ‘updating’ the RSI would be Constance Brown’s Composite Index, which measures momentum with the RSI. An easy way to think about the MFI is as a volume-weighted RSI.

Do note that just like the RSI, the MFI is considered a bounded oscillator, meaning it only measures and prints values between 100 and 0.

 

Money Flow Index (MFI) Formula

The MFI measures movements into and out of instruments by labeling them ‘up’ days and ‘down’ days.

When you look at where the MFI line is on a chart, you look at the time period’s average price multiplied by the time period volume. The first part of the formula is identifying the money flow value:

MF = {(High + Low + Close) / 3} * Volume

After the money flow value, the Money Flow Ratio (MFR) is calculated.

If the MF is greater than the prior period, this is known as Positive Money Flow (PMF), with the inverse as Negative Money Flow (NMF). The default period for the MFI is 14.

To determine the Money Flow Ratio, the sum of the total PMFs in the 14-period range is divided by the sum of the total NMFs in the same range.

MFR = sum of PMFs / sum of NMFs

Once MF and MFR have been established, the final calculation occurs to provide the MFI value:

MFI = 100 – (100 / (1 + MFR))

How the MFI is Used

Thankfully all of the above calculations happen automatically.

While the calculations behind how the MFI is plotted may seem wordy, thankfully, the way traders apply it in their analysis is more straightforward.

Because the MFI is derived from Wilder’s RSI, it should be no surprise that the MFI uses many of the same pieces of data to identify trading opportunities. This is chiefly done by identifying divergences.

Divergences are differences in structure between an instrument’s price chart and a corresponding oscillator. In the RSI, Wilder’s primary divergences called out attention to were:

  • Regular Bullish Divergence
  • Regular Bearish Divergence
  • Hidden Bullish Divergence
  • Hidden Bearish Divergence

These same types of divergence are found in the MFI. Do note the difference between the regular and hidden divergences, though.

Regular bullish and bearish divergence gives traders a warning that the current trend may end soon and turn into a corrective or broader reversal. Regular divergence is counter trend analysis.

Hidden bullish and bearish divergence gives traders a warning that a move returning to the prior trend is likely. Hidden divergences almost always appear at the end of a corrective move. You’ll see them often in bullish and bearish continuation patterns like flags and pennants.

Regular Bullish Divergence

 

A regular bullish divergence occurs when a price chart shows lower lows, but the oscillator in the identical period prints higher lows.

This is a warning sign that the current move lower may be turning around and instead move higher. Positive expectancy rates for a reversal or correction are higher if the MFI is around the level 20 value area.

Regular Bearish Divergence

 

A regular bearish divergence occurs when a price chart makes higher highs, but the oscillator in the same period prints lower highs.

This is a warning sign that the current move higher may be turning around and begin a new corrective move or trend reversal. Ideally, the MFI would be near the 80 value area for a trend change or corrective move.

Hidden Bullish Divergence

 

Hidden doesn’t mean sneaky or that it’s hard to find; hidden means we swap the measurement.

In regular bullish divergence, we measure lower lows in price against higher lows in the MFI. For hidden bearish divergence, we want to look for higher lows on the price chart and lower lows in the MFI.

Hidden bullish divergences are only valid if the prior overall trend was bullish – they should be ignored if the instrument is already in a bear market.

Hidden Bearish Divergence

 

For hidden bearish divergence, analysts look for lower highs on the price chart and higher highs in the MFI.

The hidden bearish divergence that appears in an uptrend needs to be ignored and is not valid – it is only helpful if the prior trend was bearish.

Extremes in the MFI

Just as with a traditional RSI, the MFI is often used to spot overbought and oversold market conditions. Values above 80 are said to be overbought, while values below 20 are considered oversold.

If only it was that easy though. The MFI is simply a calculation on price and volume that might aid you in spotting potential short-term tops and bottoms.

Just as you can’t wire the electricity in a house because you found an electrician’s toolbox, don’t assume you can short extreme readings in the MFI without a compelling reason to do so.

That’s not to cast aspersions against the MFI, it’s just to stress that sometimes, new traders can get caught up in a binary reading of a technical oscillator that doesn’t have a ton of meaning without context.

Consider this.

Think of a relentless momentum stock on a run.

Tesla in 2020 for example. Many times throughout it’s rally, it was oversold on the MFI indicator. Would you short the stock purely because of the indicator reading? We all know how many astute traders and investors got taken to the cleaners trying to step in front of that momentum.

When regular divergence shows up near the extremes, don’t assume that a reversal is immediate or likely. Instead, regular divergences can also turn into trend continuation setups. This can occur when the MFI is trading at 80, slides slightly lower then quickly returns to 80.

Smarter discretionary traders utilizing an indicator like MFI will typically have a specific reason they want to make the trade, then use the MFI as an entry signal.

Perhaps they identify a bearish candlestick pattern that indicates a potential short-term top. Or maybe a trend is losing steam and failing to make new highs.

Bottom Line

The Money Flow Index is a modified RSI. Tons of traders have been utilizing the RSI indicator successfully and unsuccessfully for decades.

They say “if it ain’t broke, don’t fix it,” but we should consider that the RSI was developed by Welles Wilder in the 1970s, when computing power was limited. So if adding a volume component to RSI makes it work better, than we should use it.

But the question is, does it really work better than the RSI? That really depends on what you’re testing.

Maybe you’re backtesting a very basic mean reversion system where you fade extreme readings on the indicator. Or maybe you’re using complete discretion.



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