Out of the many technical tools available to investors and day traders, the oscillator ‘money flow index’ is particularly powerful, and relatively little known. Normally available on a mini-chart below the main price history, learning how to read money flow index (MFI) is a worthwhile time investment for all forex traders.
Finding out how to use any technical indicator takes time and patience, but this guide should help you get started on using MFI to improve your trades – and also some advice on how to avoid mistakes and false readings.
What is the Money Flow Index?
MFI is a technical oscillator, a class of technical indicators sometimes known as momentum indicators. The index oscillates in a range to indicate whether an asset is ‘overbought’ or ‘oversold’. It is very similar to the better-known Relative Strength Index (RSI), but unlike RSI, MFI includes information about trading volume. The index is bounded between 0 and 100.
Because the MFI indicator uses trading volume as well as price data, it is considered a leading indicator. In theory, this means MFI can be used to predict future price movements. Researchers at the University of Vaasa have found MFI, when used in conjunction with RSI, has measurable trend-predicting abilities.
Like all technical indicators, MFI relies on the idea of market sentiment – that markets move in a particular direction based on overall ‘mood’, and that this leads to consistent trends and predictable patterns. By including volume as well as price information, MFI aims to produce an accurate proxy of market sentiment.
How do traders use MFI?
MFI is useful for traders to predict changes in trend direction. There are three main ways it can do this:
- Crossing into an overbought or oversold level
- Diverging from the price trend
- Failure swings
Overbought and oversold
The key principle underlying oscillators is ‘mean reversion’. This is the tendency of prices to return to their average, rather than continually moving in one direction without end. You will sometimes hear this reversion to the mean called a ‘correction’, particularly if it is a downward movement. Corrections can indicate the end of a trend or just a temporary reversal.
When MFI is high, it indicates that the asset is overbought, and when it is very low, oversold. When an asset is overbought, a downward correction is expected, and likewise, when it is oversold, you would expect to see an upward price movement soon.
While traders agree these readings indicate a trend reversal and reversion to the mean, some traders disagree on where to set levels. Most would consider an MFI reading of over 80 to indicate overbought, and below 20 oversold, but a minority of traders set these levels at 90 and 10 in order to only pick up on strong signals – you must use judgement to decide which levels you are most happy with.
Some currency pairs (such as long-term charts for GBPUSD) have traded within the 20 – 80 MFI range continuously for years – in this case, the index is still useful for divergences and failure swings. Generally, shorter-term charts will show more extreme swings in MFI; for this reason it is popular with day traders.
Divergences
Sometimes a trend in price movements will separate from the MFI trend in what is known as divergence. If the price is trending upwards, but a downward trend is underway in the MFI, this could be a sign that the price rally is weakening due to drops in volume, and that a reversal is imminent.
Conversely, if the MFI is trending upwards while prices fall, this is a strong signal that the market is about to go into an upward correction. In these cases the trader looks at trends in the MFI rather than its absolute level – MFI does not need to go above 80 to confirm an upward trend.
Failure swings
A bullish failure swing is when MFI briefly spikes above 80, before dropping back below, still maintaining its peak and increasing again, but failing to breach 80 on the second swing.
A bearish failure swing is identical but in reverse, with MFI falling below 20, then stabilising just above, before failing to push below 20 again on the second swing.
In both cases, this is a signal of an imminent trend reversal, and the second, failed swing is normally a price high or low point.
Tips for trading with MFI
- Be aware that different traders will use different overbought and oversold levels
- Be careful: Predicting reversals is always difficult, so use a tight stop loss and pay attention to other risk management
- MFI is a leading indicator, so gives an indication of future prices
Another important point to bear in mind is when the MFI is giving a clear overbought or oversold signal, it’s always possible news reports could be driving the trend. If a currency is weakening because of bad economic data, political instability, or rising inflation, then it may display an oversold signal for a sustained period of time. Always use MFI in combination with other technical and fundamental analyses.
Using MFI with forex
Since MFI was originally developed for use with equities, it is important to be aware of some limitations when applying the indicator to forex trading. Unlike exchange-traded products which report accurate volume data, the size and decentralised nature of the forex market can make estimating volumes difficult.
One solution is to use ‘tick volume’ as a proxy for real volume. Tick volume refers to the number of small price updates in a period and is an imperfect but strongly correlated indicator of real volumes. Another solution, less commonly used by retail traders, would be to look at futures volume in the same currency pair since futures are an exchange-traded product which report volumes.
Most trading platforms providing an MFI index will use the tick method or show volumes based on their own orders. You will not normally need to calculate MFI yourself.
MFI calculation
Although many trading platforms include technical oscillators like the MFI as part of their charts package, it is useful to know how the calculation works. There are a few simple steps:
- Calculate the average price for each session: (high + low + close / 3)
- Calculate ‘money flow’: average price * volume (for FX traders, volume is calculated using tick volume)
- Use a default of 14 periods of any length. Divide the sum of positive flow periods (periods where money flow is greater than the previous period) by the sum of negative flow periods (where money flow is lower than the previous period) to get the money flow ratio.
- Use the following formula to convert the money flow ratio into the money flow index:
MFI = 100 – (100 / (1 + MFR))
Remember: You don’t need to calculate MFI yourself if it’s included in your charting package, but it’s very useful to understand the method.
A word of warning
Always think about the bigger picture when considering MFI readings in making a trade. Is there a good reason why a currency may have had a long rally, that may continue despite MRI indicating it is in overbought territory? Make sure to check using other methods, and pay attention to price patterns as they appear. No one indicator is infallible.
Much of the skill in technical analysis rests on combining signals from different indicators, patterns, and awareness of general trends. If MFI indicates a price move you have other evidence to support – for example becoming oversold near a major resistance point, then the signal should be considered more powerful.
How Rakuten can help
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