- The money flow index is a technical indicator used to analyse the stock market.
- Traders use this indicator to find the points at which the stock is overbought or oversold.
- This indicator is also used to identify the changes in trend direction.
- Price and volume of stock traded are used as inputs for the MFI indicator.
Formulae used for MFI indicator:
- MFI = 100 – (100/(1 + Money Flow Ratio))
- Money Flow Ratio = (14 period positive money flow)/(14 period negative money flow)
- Raw Money Flow = TP * volume
- TP = Typical Price = (High + Low + Close)/3
- Calculate the TP for each period and compare it with that of the previous value.
- If it is greater than the previous value, raw money flow is positive. Similarly, if the value is lesser than the previous value, raw money flow is negative.
- Accumulate all the positive and negative raw money flows over the last 14 periods.
- The ratio of the above computed positive and negative raw money flows gives MFR which can be substituted in the formula to get MFI.
This is the 1 day chart of Infosys Ltd around Jan-Aug, 2020
- MFI value generally ranges from 5 to 95. However the extremes are met very rarely.
- A value around 80 indicates that the stock is overbought. Existing traders can exit their long positions and initiate long unwinding. New traders can enter the market and initiate their short positions.
- Similarly, a value around 20 indicates that the stock is oversold. Existing traders can exit their short positions and initiate their short coverings. New traders can enter the market and initiate their long positions.
- However, it would be much better if the traders enter the market after the value moves higher than 90 or less than 10.
- As mentioned above, MFI can also be used to spot trend changes using the divergences. A divergence is observed if the indicator moves in the direction opposite to the price.
- If the indicator is rising when the price is falling or flat, a divergence is observed. It could signal a trend reversal and price might start rising.
- Similarly, if the indicator is falling when the price is rising or flat, a divergence is observed. It could signal a trend change and the price might start falling.
- The main disadvantage of MFI is it produces false signals sometimes. It happens in the case of divergences.
- Divergence doesn’t always indicate a trend reversal and inexperienced traders are unaware of this. They may fall into losses if ignored.
- Hence, MFI should be used with few other indicators to better analyse the market.