Money Flow Index Indicator Explained

Definition of the Money Flow Index Indicator

The Money Flow Index is an indicator that utilizes the volume and volatility of an asset to determine the buying or selling pressure of an asset. The indicator was developed by Avrum Soudack and Gene Quong as a volume-weighted variation of the RSI.

The Money Flow Index is calibrated from 0 to 100, and creates a money flow ratio (Positive Money Flow to Negative Money Flow) over a time period. This money flow ratio is what is pushed into an RSI formula to create a momentum indicator. Being a momentum indicator, the Money Flow Index (MFI) is capable evaluating overbought and oversold market conditions, using values of 80 and above for overbought conditions and 20 and below for oversold situations.

MFI

Money flow is deemed to be positive when there is increased buying pressure, leading to rise in price of currency pair. Money flow is negative when there is increased selling pressure, leading to drop in price of currency pair.

MFI can also be used for divergence trades, as divergence between peaks and troughs of the MFI and the price action can produce trading signals.

Components of the Money Flow Index
The Money Flow Index is made up of three components.

a) The indicator line which is a measure of price and volume weighting set to 14 periods.
b) Overbought zone
c) Oversold zone
The calculation of the Money Flow Index is by multiplying the typical price by the volume:

Typical Price = (High + Low + Close) / 3
MFI = Typical Price X Volume

Usage of Indicator

The Money Flow Index shares resemblance to the Relative Strength Index, so it can be used in the ways the RSI is used. More importantly, it also incorporates the volume of trade by buyers and sellers into the calculation, so it is capable of producing trading signals much earlier than the RSI can.

Indicator Settings

The indicator is listed on the MT4 as a volume indicator. To attach it to the MT4 chart, click on Insert -> Indicators -> Volumes -> Money Flow Index

MFI2

The indicator line of the Money Flow Index indicator can be enhanced by either increasing the line thickness or by changing the colour of the indicator to make it more visible.

Usage of the Money Flow Index in Forex Trading

The Money Flow Index can be used in forex trading in the following ways:

a)As a standalone indicator

As a standalone indicator, the Money Flow Index can be used in divergence trades. The divergence in this case would be to look to see where the peaks and troughs of price action deviate from the peaks and troughs of the Money Flow Index. Trend lines are used to connect the peaks and troughs of both price action and the MFI. Whenever a divergence is detected, it represents a trading opportunity as price action will try to correct the divergence. The divergence situation is seen when the trend lines of price and the RSI are facing different directions. The entry for any divergence trade must be made using technical parameters such as candlestick or chart patterns.

MFI_divergence

The example above shows a typical divergence trade. The MFI is showing higher lows while the price action is making lower lows. This is a bullish divergence and price is expected to correct upwards to tally with the MFI. After identifying the divergence, the trade is setup after we identify a pinbar entry candle. The exit point of this trade is when price gets to levels identified by the MFI as being in overbought areas. Note that the divergence trade was setup when price was oversold, so this was a good trade on the 4hour chart of the GBPJPY, netting 356 pips.

b)In combination with other indicators

The primary way is to trade the MFI in combination with other indicators is when trading overbought or oversold market conditions. When the MFI is 80 or >80, the market is overbought and this is a bearish signal. When the RSI is 20 or <20, this is an oversold signal and the trader would be looking to short the currency pair.

Here, you could add the coloured MACD indicator and look for something on the charts that would support a short entry when the MFI is overbought, or a long entry when the MFI is oversold.

MFI_short

This is the daily chart of the GBPJPY. We have a rising wedge forming when the MFI is overbought. The short trade is initiated at the open of the next candle which breaks the lower border of the rising wedge. We also see the coloured MACD indicator showing a red candle bar, which confirms the short entry. The trade is taken and exited when the coloured MACD bars show blue or when the MFI gets into oversold territory. This trade would have netted about 300 pips.

Conclusion

Make sure you practice how to trade each setup on a demo account before using the indicator to trade real money. Also pay attention to risk management.

Leave a Reply