Since the Money Flow Index uses volume in its calculation, this indicator can prove effective as a divergence indicator. The theory is as follows:
- If price is rising, and the volume on up days is greater than the volume on down days, then this is confirming of the price rise.
- Likewise, if price is falling and the volume on down days is greater than the volume on up days, then the recent downward trend in stock prices is confirmed.
- In contrast, if prices rise, yet the volume on the up days is less than the volume transacted on down days, then money is secretly pouring out of the stock; this is a bearish divergence.
- And similarly, when prices fall, but the volume on the down days is less than the volume on up days, then money is flowing back into the stock, a bullish divergence.
The chart below of Microsoft (MSFT) shows the effectiveness of the Money Flow Index in detecting bullish and bearish divergences:
In the chart above, beginning on the left, Microsoft's stock price is in a downtrend; however, the Money Flow Index is not going downwards, in fact, it is sloping upwards. This is a good illustration of a bullish divergence.
On the second half of the chart, Microsoft is making new highs, yet the Money Flow Index is making lower highs, a bearish divergence. Stock traders of MSFT would be advised to scale out of their position because money is flowing out of Microsoft stock.
Later, the price of Google increased, and the MFI indicator confirmed that increase. This is a signal that the trend in Google still has buying pressure and that the stock trader should continue holding their long position in the stock.
The Money Flow Index is a valuable technical analysis tool due to its ability to incorporate both price and volume into its calculations. The Money Flow Index is very effective in confirming price action and warning of future price reversals.
Other technical analyis tools similar to the Money Flow Index, is the On Balance Volume indicator (see: On Balance Volume) and the Chaikin Oscillator (see: Chaikin Oscillator).
