The Money Flow Index (MFI) uses price and volume and the concept of accumulation distribution to create an overbought and oversold indicator that is helpful in confirming trends in prices and warning of potential reversals in prices. The inputs to the Money Flow indicator are given below:
- Typical Price: (High + Low + Close) / 3
- Money Flow: Typical Price x Volume
- Positive Money Flow: The Money Flow on days where the Typical Price is greater than the previous day's Typical Price.
- Negative Money Flow: The Money Flow on days where the Typical Price is less than the previous day's Typical Price.
- Money Ratio: Positive Money Flow / Negative Money Flow
- Money Flow Index: 100 - [100 / (1 + Money Ratio)]
The chart below of Google (GOOG) stock shows the Money Flow Index in action:
Interpreting the Money Flow Index
- Below 20 is considered oversold; look for buying opportunities.
- Above 80 is in overbought territory; look for sell signals.
In the chart above of GOOG, the downtrend in price was confirmed by the downtrend in the Money Flow Index. Once the MFI entered the oversold area, traders would be advised to begin to reduce their short sell positions and buy to cover.
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.
In additon to being an excellent confirmation tool, the Money Flow Index can warn of potential price reversals. Money Flow Index divergences is next.
