Trading on Cryptocurrency Bitcoin/Etherium with MFI (Money Flow Indicator)
The Money Flow Index (MFI) is a momentum indicator that measures the inflow and outflow of money into a security over a specific period of time. The MFI uses a stock’s price and volume to measure trading pressure. Because the MFI adds trading volume to the relative strength index (RSI), it’s sometimes referred to as volume-weighted RSI.
The value of the MFI is always between 0 and 100, and calculating it requires several steps. The developers of the MFI, Gene Quong and Avrum Soudack, suggest using a 14-day period for calculations. Step one is to calculate the typical price. Second, the raw money flow is calculated. The third step is to calculate the money flow ratio using the positive and negative money flows for the previous 14 days. Finally, using the money flow ratio, the MFI is calculated. Formulas for each of these items are as follows:
- Typical price = (high price + low price + closing price) / 3
- Raw money flow = typical price x volume
- Money flow ratio = (14-day Positive Money Flow) / (14-day Negative Money Flow)
Positive money flow is calculated by summing up all of the money flow on the days in the period where the typical price is higher than the previous period typical price. This same logic applies for the negative money flow.
- MFI = 100 – 100 / (1 + money flow ratio)
Many traders watch for opportunities that arise when the MFI moves in the opposite direction as the price. This divergence can often be a leading indicator of a change in the current trend. An MFI of over 80 suggests the security is overbought, while a value lower than 20 suggest the security is oversold.
While a 14-day period is typically used in calculating the MFI, for simplicity’s sake, below is a four-day example. Assume a stock’s high, low and closing prices for four days are listed along with volume as:
- Day one: high = $24.60, low = $24.20, closing = $24.28, volume = 18,000 shares
- Day two: high = $24.48, low = $24.24, closing = $24.33, volume = 7,200 shares
- Day three: high = $24.56, low = $23.43, closing = $24.44, volume = 12,000 shares
- Day four: high = $25.16, low = $24.25, closing = $25.05, volume = 20,000 shares
Using the above formula, the typical prices are:
- Day one = $24.36
- Day two = $24.35
- Day three = $24.14
- Day four = $24.82
Raw money flow for each day is:
- Day one = $24.36 x 18,000 = 438,487
- Day two = $24.35 x 7,200 = 175,323
- Day three = $24.56 x 12,000 = 289,736
- Day four = $25.16 x 20,000 = 496,400
Money flows are:
- Positive money flow = 438,487 + 496,400 = 934,887
- Negative money flow = 175,323 + 289,736 = 465,059
- Money flow ratio = 934,887 / 465,059 = 2.01
- Money flow index = 100 – 100 / (1 + 2.01) = 100 – 33.22 = 66.78
If one has traded the Relative Strength Indicator (RSI), then they would not have much trouble incorporating the Money Flow Index into a day trading. This is because the Money Flow Index indicator also fluctuates between 0 and 100, as discussed above.
If the Money Flow Index reading is above 80, one should be very cautious about the uptrend as anything around level 80 indicates an overbought market condition where the price may start a short-term counter move or retracement.
By contrast, when one finds the Money Flow Index reading below 20, one should start to reduce a short exposure as it indicates the stock is oversold and the price will likely increase.
Since the Money Flow Index is a momentum oscillator, you use this to confirm the price action. If the Money Flow Index is declining and a trading system generates a sell signal, the odds of the stock price going down would be much higher. Similarly, one can utilize the Money Flow Index indicator for taking a long position when the money flow index chart is going up.
There is another way one can use the Money Flow Index indicator, and that is as a divergence signal. If one find that the stock price is going up, but the Money Flow Index is declining, it would provide insight that the uptrend is weak and should not be trusted. A divergence like this indicates that the stock price would likely start a correction phase. One can apply the same divergence strategy when the price is falling, but the Money Flow Index is rising.
There is no definite response to the question on what is the real trading strategy to apply. This indicator should always be used with discretion and never as in itself providing the trader with exact orders to enter or exit the market.
We can use this indicator to identify mainly two conditions of the market. These conditions can, in association with a broader understanding of volume that is provided by our trading course, give us insights into a trading strategy.
Reversals. Extreme values in MFI are indicative of potential reversals in the market. When the price moves to an extreme value it essentially means that not only are there higher volumes of capital in the market but also that they achieved relative gains that are also extreme. Joining volume and RSI allows for this conclusion.
When the indicator shows an overbought condition – above 80 – or oversold condition – below 20 – the trader should be on alert for a potential reversal. Being an oscillator, the MFI is, therefore, a powerful solution to get a better grasp of what goes on in the market and whether price has achieved extreme values.
Divergences. But there is also another way to use MFI – through an assessment of divergences of price and the values showed in the indicator. So let’s just assume that price achieves an overbought condition (above 80), and then continues in the same direction but the MFI shows a lower value. This essentially means that even though price has continued to move higher, the volume is drying and the relative gains are statistically inferior. The trader should be aware that this divergence between price and indicator is another potent sign of reversal.
The same occurs for oversold conditions (below 20). When price continues to move down but the MFI starts to climb above the oversold condition, this indicates a possible reversal of price.
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