Money Flow Index Strategy (MFI) | Backtest Analysis
Understanding volume and price, and how they can influence the market, is very important in trading. Since volume is the measure of activities in the market, traders can use the information provided to increase the probability of their trades. A great indicator that combines price action and volume is the money flow index. Now, what is a money flow index?
The money flow index (MFI) is a momentum indicator that measures the flow of money into and out of a security over a specified period of time by combining price and volume data. It oscillates between 0 and 100 and shows overbought and oversold conditions in the market. The indicator can be used for predicting potential price reversal points in the market.
This article focuses on the money flow index and how traders use it in their trading. At the end of the article, we provide a backtest of the strategy.
What is the money flow index?
The money flow index indicator or simply the MFI oscillator is a popular trading indicator used for predicting reversals in the market. It is used to gauge the buying and selling pressure within security. Just like conventional momentum-based indicators, the MFI oscillates between 0 and 100 and shows overbought and oversold conditions in the market.
One interesting thing about the MFI is that it does not consider only price but also includes volume. In fact, it can be considered a volume-weighted Relative Strength Index indicator because its formula is similar to that of the RSI but with volume added to the mix.
The MFI generates signals similar to those seen on several other technical indicators. This consists of producing oversold and overbought signals as well as the common bullish and bearish divergence signals. The overbought signal is given whenever the indicator is above 80, while the oversold signal is generated when the indicator is at 20 or below.
A bullish divergence MFI signal would occur when the price is creating lower lows or in a downtrend and the MFI is creating higher lows or in an uptrend. In the same way, a bearish divergence MFI signal would occur when the price is creating higher lows or in an uptrend, while the MFI indicator is creating lower lows or in a downtrend. To spot a divergence, you can employ the use of trendlines on both price and the indicator.
The money flow index indicator is commonly used to trade reversals. For this, traders typically look for a cool-off in momentum in an uptrend as the indicator reaches the overbought level or when a bearish divergence signal is generated to know that the uptrend may soon turn to a downtrend. On the flip side, traders will look out for a cool-off in selling pressure in a downtrend when the indicator approaches the oversold level to anticipate an upward reversal.
Money flow index formula
The mathematics behind the money flow index is a bit complex. To get the indicator reading, we have to:
- Determine the typical price. This is gotten by adding the high, low, and close and dividing by three. If the typical price for today is less than that of the previous day, this indicates a negative money flow. Whereas if today’s typical price is greater than yesterday’s typical price, then we have a positive flow.
- Calculate the raw money flow. It is computed as the product of the typical price and volume.
- Next, calculate the money flow ratio as the positive money flow of a given period divided by the negative money flow of a given period.
- Finally, the money flow index is calculated as follows:
Calculating this manually can be quite confusing especially if you are not the type who loves mathematics. This is just to help you understand the principles of generating the figures on your indicator. The indicator is usually built into most trading platforms and simply plots the line when attached to a trading chart.
What is the best money flow indicator?
People usually confuse the Chaikin money flow (CMF) oscillator created by Mark Chaikin and the money flow index created by Avrum Soudak and Gene Quong. The similarities between the Chaikin money flow oscillator and the money flow index end with the idea that they are both commonly used by active traders to monitor the flow of money and/or momentum.
While CMF is based on price data alone and uses two exponential moving average to estimate price momentum, the MFI combine price and volume data in calculating market momentum. Both indicators are good in their own way, and which is best depends on how the trader wishes to use them. However, some traders may prefer the MFI because it includes the volume data in the calculation.
Is the money flow index a good indicator?
The performance of an indicator is dependent on many factors.
Most importantly, the techniques of the user would be a determining factor. In general, the MFI is a reliable indicator that helps to tell you the direction of money flow in a given security.
For instance, if you are long a stock and suddenly the MFI is dropping to lower levels, this could mean that more people are cashing out of the stock and may indicate a change in trend — alerting you to plan to exit. Same way, it can give you confirmation when looking to buy a stock. A rising price with a rising MFI simply tells you that more money is flowing into the given security.