Last Updated on Aug 31, 2021 by Aradhana Gotur
When you are trading on the stock exchange, you need to be careful when picking the right kind of stock. While it is difficult to time the market, an entry at the right time can earn attractive returns. Investors use various indicators to track stock price movements and identify patterns. The Money Flow Index (MFI) comes into play here and is an important indicator.
This article covers:
- What is the Money Flow Index?
- How to calculate the Money Flow Index?
- Using the Money Flow Index
- Limitations of the MFI indicator
Table of Contents
What is the Money Flow Index (MFI)?The Money Flow Index measures the trading pressure on a particular asset, usually a stock, by assessing the price and volume of trading. Click To Tweet
The MFI acts as an oscillator, called the MFI indicator, that ranges between 0 and 100. It helps in signalling the overbuying or overselling of the asset as well as divergences that predict a reversal in market trends.
Since the MFI uses price as well as volume traded to measure the trading pressure, it is also called a volume-weighted Relative Strength Index (RSI).
How to calculate the Money Flow Index?
The calculation of the MFI is a four-step process because you need to generate the different input values that are used to calculate the index. Here’s how you can calculate the MFI:
Step 1: Calculation of the Typical Price per period
The Typical Price is the average price of the stock over a day. It is calculated as follows:
Typical Price = (The highest price of the stock + the lowest price of the stock + closing price of the stock) / 3
For example, if, on a trading day, a stock reaches a high of Rs 120 and a low of Rs 105 and closes on Rs 117, the typical price for that day would be – (120+105+117)/3 = Rs 114
If the typical price reduces the next day, it is a negative money flow. If it increases, it is a positive flow. So, calculate the typical price over a 14-day period and mark each price as negative or positive.
Step 2: Calculate the Raw Money Flow
The Raw Money Flow is the money generated by a particular volume of the stock at the day’s typical price.
The formula is:
Raw Money Flow = Typical Price x Volume
For example, in the above example, if the total volume of stock that is traded is 1,000 units, the Raw Money Flow would be 114×1,000 = Rs 1,14,000
When calculating the Raw Money Flow, if the typical price is negative, the money flow would be negative and vice-versa. Calculate the money flow over the 14-day period using the typical price of each day and mark each value as negative or positive.
Step 3: Calculate the Money Flow Ratio
The Money Flow Ratio is the ratio between the total positive inflow to the total negative inflow over a 14-period time frame, i.e. a 14-day period. The formula is:
Money Flow Ratio = 14-period positive inflow / 14 period negative inflow
When you calculate the raw money flow over 14 days, aggregate all the positive flows and put the value in the numerator of the above formula. Similarly, all negative flows should be added and put in the denominator.
Step 4: Calculate the MFI
When you have the Money Flow Ratio, you can calculate the MFI which is:
MFI = 100 – [100/(1+Money Flow Ratio)]
Using the Money Flow IndexThe Money Flow Index indicator, ranging between 0 and 100, proves quite useful in spotting a divergence. Click To Tweet
A divergence means when the indicator is moving contrary to the price, i.e. the stock price is moving in one direction while the oscillator is moving in another. In such cases, a trend reversal is indicated so that you can pick the right time to enter the market or exit from it. The reference points of the MFI indicator are 80 and 20 and here’s how you check the reversal trends.
If the MFI indicator starts falling below 80 when the stock price is still moving up, it indicates that the stock is overbought. It signals a downtrend telling you to exit the market and book your profits before prices start falling.
If the MFI indicator starts climbing up from 20 while the stock prices are still falling, it indicates that the stock is oversold. It signals an uptrend when the falling prices of the stock have made it lucrative for investment. This signals the right time to enter the market and buy the stock at reduced prices to make profits when prices start increasing.
Besides the levels of 80 and 20, levels of 90 and 10 are also used, though rarely. If the indicator falls below 10, it is a good time for a long trade, i.e. investing with a long term horizon. On the other hand, if the MFI indicator moves past 90, it is a signal for a short trade, i.e., buying and selling the stock within a short period of time for maximum gains.Besides divergence, the MFI indicator helps in spotting overbought or oversold stocks. If the MFI crosses 80 and keeps rising, it indicates that the stock is overbought. Similarly, if the MFI falls below 20, it indicates that the… Click To Tweet
Limitations of the MFI indicator
When using the indicator, you should understand that the indicator just signals possible trend reversals. It does not actually guarantee them. So, though the MFI indicator signals an uptrend or a downtrend, stock prices might not move as expected. Similarly, the indicator might not point out divergences for all price reversals. As such, depending only on the MFI indicator is not recommended. It is better to use other technical and fundamental analysis tools to pick the right time to invest in the right stocks.
The bottom line
The Money Flow Index can help you gauge the trading position of stock so that you can make the right investment decisions. So, understand what the MFI is all about, how it is calculated and how to use it. Also, keep its limitations in mind and use other tools with the MFI indicator to make the right investment decisions.